by Brad M. Weafer, CFA | Chief Investment Officer
Click Video Below for Quarterly Update
KEY POINTS
- Equity markets had a strong 2nd quarter led in large part by the largest companies in the U.S.
- The U.S. economy continues to defy predictions of a recession, supporting corporate profit and stock prices.
- History suggests the probability of economic weakness is still elevated, and we maintain a more moderate portfolio positioning in line with this evidence.
Second Quarter Results
The second quarter’s strong run of market returns capped an impressive first half of 2023. Equity markets rallied for a 3rd straight quarter, and despite a marked level of pessimism from financial market pundits, the S&P 500 Index entered bull market territory, rising more than 20% from its October 2022 bottom and returning an impressive 8.7% during the second quarter (see figure below). International stocks also posted positive results but trailed their domestic counterparts. Interest rates moved higher and pulled down fixed income returns (bond prices fall when rates rise). A portfolio consisting of 60% global stocks and 40% bonds, the foundation of many client portfolios, earned a respectable 3.5% during Q2 and returned 9.4% year to date. This is a welcome development after the challenging results such a portfolio experienced throughout 2022.
Performance for select asset classes as of 6/30/2023
Data Source: Bloomberg. Global equities represented by the MSCI ACWI Index, U.S. Large Cap by the S&P 500 TR Index, U.S. Small Cap by the Russell 2000 TR Index, International Developed by the MSCI EAFE TR Index, International Emerging by the MSCI EM TR Index, U.S. Agg Bond by the Bloomberg U.S. Aggregate Bond TR Index, U.S. Corp Bond by the Bloomberg U.S. Corporate TR Index, Global 60/40 by 60% MSCI ACWI and 40% Bloomberg U.S. Treasury Index, Commodities by the Bloomberg Commodity TR Index, and Real Estate by the Dow Jones U.S. Real Estate TR Index.
Equity Performance Driven By A Select Few
The strong returns for the S&P 500 are a welcome development. However, it has not been “a rising tide lifts all boats” type of market. A majority of the strength has been generated by only a handful of stocks. A group of the largest companies in the S&P 500, dubbed by some as the “enormous eight”, collectively contributed approximately 80% of the return for the entire index despite making up just 2% of the collective 500 companies. The remaining 492 stocks (98% of the index) contributed just 20% of the returns. This phenomenon is also illustrated by comparing performance to other indices not weighted by the size of the company. The equally weighted S&P 500 Index trails the headline index by close to 10% year to date, and the small companies index (the Russell 2000) trails the S&P 500 by 8%. Groups of stocks that have historically behaved defensively and are favored by more conservative investors have also failed to keep pace. For instance, the NASDAQ U.S. Broad Dividend Achievers , an index consisting of companies that have increased their dividend payout each of the last 10 or more years, trailed the S&P 500 by over 11% at the end of the quarter.
Resilient U.S. Economy
My father was a Marine and he was fond of telling me to “hurry up and wait” whenever I was impatient. I suspect many investors with downbeat forecasts for markets and the U.S. economy could use that same advice. The lagged effect of restrictive monetary policy (i.e. higher interest rates) finally seemed to be biting at the end of the first quarter with turmoil in the banking sector. But even two of the largest bank failures in history have failed to generate any material economic weakness in the ensuing months. The U.S. economy has thus far proven resilient and adaptable. Inflation, as measured by CPI, has steadily marched lower from a high of 9% in June 2022 to 3% in June 2023. Despite repeated warnings that a recession is imminent, unemployment has stayed below 4% for 17 straight months. This is a remarkable stretch for workers that rivals anything we have seen in the last half-century (see figure below). Lael Brainard, Director of the National Economic Council of the United States and former Vice Chair of the Federal Reserve put it succinctly, “The economy is defying predictions that inflation would not fall absent significant job destruction”. Financial markets present a live look at the crowds’ expectations of companies’ future financial performance. Ms. Brainard was right, the economy has defied predictions and stock prices have reacted accordingly by revising the assessment for the durability of all companies’ profits. The longer we get to hurry up and wait for economic weakness, companies can continue to drive profits for shareholders unperturbed by declining demand that accompanies recessions.
U.S. Unemployment Rate
Source: U.S. Bureau of Labor Statistics. Gray shading indicates periods of recession.
Playing the Odds
If the vast majority of professional forecasters were expecting a recession, how could so many have been so wrong? None of these folks have a crystal ball. Instead, these astute economists and investors try and predict the future based on historical odds. In the post-war era, the U.S. Federal Reserve has embarked on 13 cycles of tightening financial conditions, illustrated on the chart below with a rising federal funds rate. Ten of those instances ultimately resulted in a recession, denoted in the gray shaded regions. Only the 1966, 1983, and 1995 instances avoided this fate. With fiscal debt reaching new highs that were once unimaginable, and an economy weened on effectively zero interest rates for a decade and a half, defying those odds seemed farfetched, especially given the speed and magnitude of the rate hikes.
Federal Funds Effective Rate
Red arrows indicate periods of tightening prior to a recession
Data Source: Board of Governors of the Federal Reserve System (U.S) . Shaded areas represent periods of economic recession.
Timing, of course, is key. What is evident from the chart below is the wide dispersion of lead times from the start of rate hike cycles to the start of a recession. Capital markets are forward looking and begin to embed expectations of future trouble ahead of time. Typically, when the yield curve is inverted (when the difference between ten-year and two-year rates on U.S. treasuries goes negative) it suggests the market believes the tightening cycle has finally gone too far. The yield curve has inverted seven times in the last 50 years including the most recent inversion last April. In the prior six instances, the stock market reached an ultimate peak, on average, 15 months later. History supports the notion that we are getting closer to the end of the market cycle, but calls for a recession that were so prevalent last year may have just been too early. Stock markets have been catching up to this fact all year.
Better To Be Early Rather Than Late
With investing, being early is often considered consistent with being wrong. Positioning portfolios more moderately has led to lower returns thus far in 2023. Balanced portfolios with a higher mix of lower-risk assets like U.S. treasury bonds are trailing more stock-heavy portfolios. A similar case can be made in equities, where aggressive allocations to high valuation and growth-oriented portfolios have outpaced more moderate strategies favoring high-quality and dividend paying companies more broadly. This lens however is far too short-term and ignores the simple fact that true wealth creation over time comes more from protecting capital when markets decline and having the ability and willingness to capitalize when they do. William Shakespeare had it right when he said, “Better three hours too soon than a minute too late”. We take solace from the fact that portfolios positioned more moderately are still earning exceptional returns and are doing so at a lower level of risk. It is certainly easier to “hurry up and wait” when equities are earning double-digit positive returns!
Portfolio Positioning
We continue to respect the history of recessions and market declines that typically follow aggressive Federal Reserve tightening cycles. In today’s rapid news and social media cycle, patience is an almost forgotten virtue. In this climate, it is easy to think that the early warning signs of recession have been with us for an excruciatingly long amount of time. A more careful review of the past suggests we are only just now reaching the historical averages. This is a simplified explanation and glosses over the vicissitudes of every idiosyncratic cycle. However, we are more comfortable sticking with more moderate positioning when alternatives to risk assets carry the acceptable levels of returns we find in the fixed income market today. We maintain stock exposure in client accounts at the lower range of long-term targets and are at the higher end of targets for U.S. Treasury and high-quality corporate bonds. We continue to also allocate, where appropriate, to non-traditional alternatives such as private credit and managed futures, assets with characteristics that differ from traditional stocks and bonds. Within equities, we stand by our position that high-quality stocks marked by high profitability, low leverage, and durable growth in cash flow and dividends provide above-average returns with lower volatility. Portfolios constructed with diversified asset classes and quality stocks should continue to reward investors over time.
If you have questions about the capital markets, your portfolio, or how your assets are invested, please reach out to your wealth manager. We are always happy to take your calls and questions.
Market Commentary Disclaimer
This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.
Professional Designation Minimum Requirements Disclosure
CFA® – Chartered Financial Analyst. Minimum requirements for the CFA® designation include an undergraduate degree and four years of professional experience involving investment decision-making, in addition to successful completion of each of the three CFA® level exams.