U.S. equities ended the first half of 2023 higher with most of the gains made in the last month of the second quarter. The S&P 500 Index ended the quarter at a 14-month high and most major market indexes also posted solid gains, led by the tech-heavy NASDAQ, which saw its best half of the year in four decades. Growth stocks vastly outperformed value stocks for the second straight quarter, continuing the sharp reversal from 2022. Small-caps lagged their large-cap counterparts. Eight of the eleven S&P 500 sectors finished the second quarter with positive returns. The surge in selected mega-cap stocks such as Amazon, Apple, Alphabet and Meta drove the gains in consumer discretionary, technology and communication services, which heavily outperformed the remaining sectors, building on their good results during the first quarter of the year. Industrials, financials, and materials saw moderate gains over the past three months, and traditional defensive sectors like consumer staples and utilities declined slightly. While the second quarter returns for the most major market indexes are quite impressive, the market upward move was rather narrow. If we remove the market’s upward bias produced by big tech stocks, the Invesco S&P 500 Equal Weight exchange traded fund, which represents “average stock”, was up only +6.9% year-to-date after its February 2nd peak of +10.0%.
The international equity performance results were also positive, albeit foreign markets lagged the U.S. due to the relative lack of hot mega-cap stocks in major foreign market indexes. International developed markets outperformed emerging markets thanks to a lack of significant economic stimulus in China, which weighed on emerging markets late in the quarter.
The U.S. Treasury yield curve was up across the maturity spectrum during the quarter. The 10-year Treasury yield ended the quarter at 3.84%, up from the end of March.
The second quarter brought the first pause in the Federal Reserve’s blistering campaign of rate hikes that started in March of last year and brought interest rates to a 16-year high. After ten consecutive increases in the fed funds target rate, all the members of the Federal Open Market Committee agreed unanimously to temporarily halt further increases in June. Inflation, as measured by the Consumer Price Index, has dropped from about 9% at its peak last year to about 4% in May, however it is still double the Fed’s goal of 2%, and the rate hikes resumed in July.
Our domestic economy grew solidly in the first quarter and remained clear of recession despite the Federal Reserve pushing interest rates higher. Gross Domestic Product grew 2.4% annualized in the first quarter of 2023, up from its initial 1.9% estimate. Over the last year, the economy has added 4 million jobs, almost half of which were added in the first half of 2023. The strong demand for labor with 10 million job openings to only 5.7 million unemployed has resulted in above-average wage growth. With more dollars in every paycheck, U.S. consumers kept spending and consumer confidence, which hovered near historical lows for most of the last year, climbed to its higher level since September 2021.
Vehicle production, previously held back by a shortage of semiconductors, soared 20%, annualized, in the second quarter. This enabled businesses to sharply boost investment in equipment, even as prices for that equipment fell for the first time in two years.
Still, there were some reasons for concern as some economic indicators signaled slowing economic activity ahead, as the Leading Economic Index fell in June for a fifteenth consecutive month. That was the index’s longest streak of decline since a span from the spring of 2007 through early 2009. Moreover, the bond market is flashing another warning sign with the 10-Year Treasury note yield staying lower than that of the 2-Year Treasury for more than a year, the longest period since the 1980’s.
As we reached the midpoint of 2023, global economies and markets were still facing some uncertainty and challenges. Recently, Fitch Ratings, a service that rates the quality of bonds, downgraded U.S. Treasuries from AAA to AA+ stating that its longer-term projections forecast additional debt/GDP rises, increasing the vulnerability of the U.S. fiscal position to future economic shocks. Lending standards have tightened, and a tighter lending environment historically suggests a downside to S&P 500 earnings. While a recession is now seen as a less likely scenario this year, economic concerns have not disappeared. A recession probability model run by the New York Federal Reserve based on the Treasury yield curve earlier this month projected a 71% chance of one in the next 12 months. The market gains of the first half of the year were mainly led by a handful of large stocks, and while it is not uncommon for the largest stocks to dominate performance in cap-weighted indexes, the concentration risk becomes elevated with the majority of stocks underperforming the overall index. The improvement in market broadening, which started at the end of the second quarter, needs to continue for the market rally to be sustainable.
The second half of 2023 holds the potential for fewer surprises, with the U.S. debt ceiling deal in place until early 2025, bank stress stabilizing, and global central banks moving towards a pause on rate hikes. Over the last four hiking cycles since 1995, the markets generated strong returns for both stocks and bonds.
As always, we find it dangerous to simply chase the companies that are driving the latest market gains. Rather, we believe that investing in a broadly diversified and risk-appropriate portfolio of quality companies represents the best course of action. Successful, goal focused investors should ignore the news and understand the difference between investing and speculating. Investing is a marathon, not a sprint, and even intense volatility is unlikely to alter your long-term investment goals.
Dumont & Blake Investment Advisors, LLC
June 30, 2023