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Executive Summary Quarterly Report
- The second quarter of 2023 continued the positive start we saw in the first quarter. The S&P 500 was up 8.7% for the second quarter, the NASDAQ was up 13.09%, and the Russell 2000 was up 5.1%.
- June saw greater market “breadth,” with less concentration of returns in a relatively few numbers of Mag Cap companies.
- While the stock market was up significantly in the second quarter, the bond market was down 0.8%. Rates are back to being near where they were at the beginning of the year.
- The Fed FOMC did not raise rates at the June meeting but indicated they will raise the Fed Funds rate more in 2023.
- Futures markets no longer anticipate a 1% cut in the Fed Funds rate by the end of the year, although a more modest cut is expected at the January 2024 meeting, at least for now.
- A mild economic slowdown is probably ahead in 2023, but near-term volatility should be used as an opportunity to position for a sustainable recovery.
The second quarter of 2023 continued the positive start the market saw in the first quarter. The S&P 500 was up 8.7% for the second quarter, with 6.6% coming in June. For the first two months of the quarter, we continued to see a concentration of returns in the market in a relatively small number of Mega-Cap Tech stocks. Between the end of March and the begging of May, only three sectors were up - Communications Services, Information Technology, and Consumer Discretionary, the same sectors that dominated returns all year. June showed broader market participation, which is what we expect to continue to see throughout the rest of the year. Smaller-cap stocks and more cyclical companies played catch-up in June, with the NASDAQ up 6.66% and the smaller-cap Russell 2000 up 8.02%.
Despite this leveling in returns in June, returns for the quarter and the year are still significantly higher for the tech heavy NASDAQ index, which was up: 13.09% for the quarter and is up 32.37% on a year-to-date basis. In comparison, the S&P 500 was up 8.7% for the quarter and 16.85% for the year, while the Russell 2000 was up 5.1% for the quarter and is up 7.92% for the year. All together, we see a significant change from 2022; as at this point last year, the S&P 500 was down 20%, and the bond market was down 10% before finally ending 2022 down 18% and 13% respectively. The market has been boosted by changes in Fed rate policy, improving inflation, a surprisingly resilient economy, and the late optimism around artificial Intelligence. The S&P 500 is up more than 20% since bottoming last October. The market seems to have shrugged off the banking issues of last March.
The strong start for the market in the first half of 2023 is a good omen for the market for the rest of the year. 2023 is the fifth-best start for the S&P 500 since 1990. In those years when the market was up that much, the S&P 500 recorded an average return for the entire year of 33%. Strong first halves are a great indicator for full year performances. Since 1990, the stock market has gained more than 10% in the first half on ten occasions and rose further in the second half in each of those years.
International stocks, with less big-cap Tech and Artificial Intelligence exposure and more Energy exposure, lagged US equity markets for the quarter and fell farther behind on a year-to-date basis. The Developed market EAFE index was up 3.2% for the quarter and 12.5% on a year-to-date basis. Emerging market stocks were up 1.3% for the quarter and are up 5% for the year.
While the stock market was up significantly in the second quarter, the bond market was down 0.8%, based on the Vanguard Total Bond Market Index. The yield on the ten-year treasury started May at 3.43%, and then climbed to 3.84% by June 30th. In May, Fed members pushed back against the “Fed Pause” narrative, stating that more action would be needed to get inflation down to the Fed’s 2% target. At the June FOMC (Fed Open Market Committee) meeting, The Fed held rates steady at 5.00-5.25%, the first time the Fed did not raise rates following ten consecutive meetings with hikes. Powell and Fed members have indicated they intend to raise rates in future meetings. In his comments, Powell said, “Nearly all committee participants expect that it will be appropriate to raise interest rates somewhat further by the end of the year.” Rates have been volatile, however, they ended June, near where they were at the beginning of the year.
The most recent inflation numbers indicate an improvement on the headline level and less of an improvement in the “Core” (ex-Food and Energy) numbers. The most recent Personal Consumption Expenditures (PCE) index showed that prices were up 0.1% in May versus the prior month. On a year-over-year basis, the PCE reading fell to 3.8%, compared to 4.4% in April. The monthly
Core PCE index, which excludes volatile food and energy costs, rose 0.3%, which is slower than April’s 0.4% monthly increase on an annual basis, core PCE came in at a 4.6%, slightly better than the 4.7% pace in April.
The updated Statement of Economic Projections (SEP), which the Fed puts out four times a year, shows a 50-bp increase in the year-end 2023 dot, meaning that the Fed anticipates two more 25-bp increases in 2023. Before the last FOMC meeting for the quarter took place, futures markets were expecting a 1% reduction in the Fed Funds rate this year. Today, however, futures markets no longer anticipate a 1% cut for the year and instead, a more modest cut is expected at the January 2024 meeting, at least for now.
The latest GDP numbers for the first quarter of 2023 came out at 2%, thanks to the US consumer and discretionary spending, which resulted from a strong labor market. Employment strength is showing signs of finally weakening, which should affect spending. GDP should slow as 2023 progresses. The much-anticipated recession has yet to appear, although we anticipate a modest one later in 2023. Goldman Sachs recently lowered their probability of a recession to 25%, but that is a minority view.
In previous commentaries, we wrote at length about the lack of “breadth” in the market, or concentration of returns in a relatively few number of companies, which has been the defining characteristic of the US stock market in 2023, particularly since the March banking crisis. The “large-cap effect” continued through May. As mentioned, several times before, the S&P 500 is a market-weighted index, meaning that larger cap companies represent a more significant weight in the index. Meanwhile, looking at a simple average of the S&P 500; that is giving the same weight to every stock regardless of the company’s size, would have yielded a negative return of 0.56% through May. In reality, the S&P 500 was up 9.64% through May; that is, a 10.2% differential just from the market cap effect. 4.2% of that differential came in May alone, following NIVIDIAs earnings report, in which the company gave blowout revenue guidance.
The market breadth started to normalize in June. The simple average for the S&P 500 was up 7.84% for the month vs. 6.6% for the S&P 500. The three sectors dominated by Mega-cap tech and FANG stocks; Consumer Discretionary, Information Technology, and Communication Services, were not the best performers in June. The Consumer Discretionary sector was the best-performing sector for the month, however this time helped by strong performances in housing and travel stocks. The information technology sector did worse than the S&P 500 index in June, and Communication Services was the second worst-performing sector overall. Cyclical sectors such as Industrials and Materials outperformed in June, as well as Financials.
Small-caps Relative to Large Caps
Russell 2000 Index Performance Relative to S&P 500 Index
The declines in the recent inflation readings as well as the end to the Central Bank’s hiking cycle have provided the foundation for the positive equity returns, we have seen so far this year. A mild economic slowdown is probably ahead in 2023, but near-term volatility should be used as an opportunity to position for a sustainable recovery. We see a continuation of the broadening of participation in the market in the remainder of 2023, including smaller-cap stocks along with Mega-Cap FANG stocks and Artificial Intelligence companies.
Regarding bonds, it is good to remember that yields peak before fed funds rates do, implying that yields should peak before the end of the year. This allows extending the duration to lock in yields before the Fed stops raising rates and eventually starts lowering rates in 2024.