Q2 2023 Insights

Global financial markets delievered mixed results during the second quarter.  Risk assets built strongly on their robust first-quarter returns.  The equity market rally, which since March had been dominated by just a handful of giant-cap companies, began to broaden out.  Meanwhile, bond markets gave up on their expectations for interest rate cuts by the Federal Reserve any time in 2023 (see Appendix A).  Sustained (though easing) inflation numbers and a resilient labor market continue to suggest the U.S. economy will glide to a soft landing or light recession rather than crash into a deeper recession, as analysts had previously forecasted.

While the increasing breadth of the equity market’s rally is encouraging, thanks to the upward charge of the “Magnificent Seven,”¹ valuations are no longer cheap.  At the end of July, the S&P 500 Index was trading at over 19.5 times forward earnings, nearly one standard deviation above its 25-year average, which notably still includes the dot-com bubble.  Furthermore, the dispersion in valuations between the top 10 and remaining 490 stocks in the Index is returning to the lofty levels witnessed in 2020-21 (see Appendix B).  Earnings disappointments, either due to a continued squeeze in profits from rising input/labor costs, a slump in demand as economic growth continues to cool from the post-pandemic peak, and/or a policy surprise from the Fed could trigger a quick revaluation of U.S. equities.

That said, while high valuations set high expectations that S&P 500 firms will have to meet quarter-to-quater, there is still cause for optimism over the medium- to long-term.  As the Fed nears the end of its most aggressive rate-hiking cycle in four decades, tamed inflation, a strong job market, and a healthy consumer base offer hope that the the U.S. market will remain a global growth star, especially as China’s economic engine continues to sputter.

Amid the uncertainty, we continue to focus on balancing upside return potential with the downside risk.  Broad exposure to the market, even at higher valuations is essential, especially as passive indexing strategies add momentum to a rally.  However, complementing that exposure with active strategies that seek to avoid the most challenged high-fliers and that offer exposure to undervalued quality companies is also prudent.  While this top-heavy market environment is reminiscent of 2020-21, a noticeable difference is the incredible opportunity offered to investors in the fixed income market.  While risk abounds in equity markets, it is now significantly easier to balance out that risk with high-quality bonds that offer compelling yields.  We do not know how the market will perform between now and the end of 2023, but we continue to prudently rebalance portfolios, improve tax efficiency, and stand ready to take advantage of market volatility should it pick up in the remaining months of the year.

Financial Market Performance

EQUITIES

Global equity markets delivered positive returns during the second quarter, as investors closely monitored central banks’ interest rate policies (see Exhibit 1).  Inflationary pressures, geopolitical tensions, and economic headwinds were still a concern, but the growing likelihood of an easing of monetary policy (now seemingly in 2024) helped market participants focus on the potential for better earnings down the road.

U.S. stocks posted another strong quarter.  Large-cap growth stocks, led by the Magnificent Seven significantly outperformed all other market caps, largely due to increased interest in generative artificial intelligence (AI).  Stocks in the consumer discretionary and communication services sectors also benefited from the enthusiasm around AI.  On the value side of the market, financial stocks stabilized as the fallout from March’s regional banking crisis appeared to be contained.

Non-U.S. developed market stocks also gained ground amid expectations of slowing inflation and a nearing end to monetary policy tightening by the European Central Bank. However, gains were somewhat muted, as the post-pandemic economic recovery in China (a key trading partner) was moving at a much slower pace than expected.  Major equity benchmarks in Germany, France, and Italy moved higher, but U.K. stocks declined due to a strengthening pound.  Meanwhile, foreign investors poured money into Japanese stocks.  The weak yen has benefited local exporters and supports a rebounding tourism industry.

Stocks in emerging markets managed small gains despite significant losses in Chinese equities.  A contraction in manufacturing activity, a slowdown in consumer spending, and increasing inflationary risks (not to mention rising tensions with the U.S.) kept investors on the sidelines.  Still, shares in India, Taiwan, and Brazil advanced on encouraging economic data, AI optimism, and easing fiscal policy concerns, respectively.

FIXED INCOME

Global fixed income markets were generally weaker during the second quarter (see Exhibit 2).  The realization that policy rates would likely remain higher for longer than previously anticipated led to a sell-off across almost all fixed income sectors.

U.S. Treasuries delivered negative returns with rates on shorter maturities rising more than those on longer maturities, further inverting the yield curve.  Most other developed market sovereign bonds lost ground as well.

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