We made it to the halfway point of 2023, and like the first quarter, the market has continued to rally. Year to date, the S&P is up almost 17%, the tech-heavy NASDAQ is up over 32%, and MSCI ACWI Ex USA (the world excluding the U.S.) is up almost 10%. However, digging a little deeper, the market rally has been led by a few large stocks. Tech stocks such as NVIDIA, Apple, Meta, Alphabet, and Microsoft have soared due to a sudden interest in Artificial Intelligence (AI) and how it may impact profits. However, when we look at the equal-weighted S&P 500, the YTD return is only 6%. That 10% difference shows returns have been driven by the biggest names in the index. This is not the broad market rally that we would expect to see at the beginning of a new bull market.
The technology and communications sectors were hit the hardest in the downturn of 2022 and are now up the most in 2023. Yet they remain historically overvalued, and fundamentally, not much has changed. The idea of AI is exciting and seems to be moving faster than expected, but what its effect will be in the near-to-intermediate term is still a question. Concerns remain on the sustainability of the most recent market moves.
Similar to the first quarter, inflation remains stubbornly high. Despite the U.S. Federal Reserve pausing interest rate hikes in June, inflation has not come down enough for the Fed to consider its mission accomplished. Still, the labor market remains resilient: unemployment is low, job openings remain high, and wages continue to tick upward. The consensus among experts is that there will be another 25 basis point raise in July and at least one more before year end.
Remarkably, the housing market seems immune to the Fed’s heavy-handed rate increases. Despite 30-year mortgage interest rates of over 7%, home builders’ stocks have outperformed, with housing prices remaining elevated, mostly due to a lack of supply. Current owners with interest rates near 3% are loathe to sell, and buyers that have seen their wages increase are ready to own a home despite high rates. Home builders are filling the gap, but not quickly enough, and home values are back on the rise.
In addition to low unemployment levels and higher wages, mortgages may be another reason the U.S. economy has proved resilient despite aggressive rate hikes. More than 60% of existing mortgage holders are sitting on rates below 4%, per BlackKnight1, causing mortgage costs to remain relatively flat, even as mortgage rates have doubled.
The 30-year fixed-rate mortgage is unique to the U.S., in most countries, loans are shorter and reprice to current market terms. For example, most mortgages in the UK reprice every two years, so interest rates have a more immediate effect on discretionary income. However, with inflation remaining high (8.7% in the UK), rates continue to go up throughout developed markets. Most central banks, including the U.S. Federal Reserve, seem willing to risk over-tightening rather than allowing entrenched inflation. As we’re continuously reminded, these methods work on a lag, so what central banks do today will continue to ripple through the economy for months or years into the future.
In addition to higher rates, we’re beginning to see lending standards tighten and the money supply decrease. Banks are making loans more difficult and more costly to obtain for both consumers and businesses. In addition, the U.S. Treasury has begun rebuilding its cash reserve after the debt ceiling resolution, further limiting liquidity in the market. Consumers are faced with higher prices, higher taxes, higher interest rates, less access to credit, and soon the return of student loan payments, all of which reduce discretionary spending. While wages have increased, they continue to struggle to keep pace with inflation. Higher wages and a tighter labor market equate to higher costs for businesses, which coupled with tighter lending standards, will also decrease spending. This will be much more apparent for companies that rely heavily on borrowing. Experts predict there will be a lot of headwinds pushing on discretionary spending levels going forward.
Emerging markets, namely China, continue to struggle. China continues to cut interest rates while the rest of the world raises them. The government has allowed its currency to weaken and continues to push money into infrastructure building. However, even with a weaker currency, exports to the U.S. are at a historic low. While most of the world battles inflation, China is on a path toward deflation.
One noticeable beneficiary of higher rates has been the fixed-income market. Positive yields are back, at least in short duration, and money market funds are seeing close to 5%. While that hasn’t kept pace with gains in the equity market, a 5% return on an almost zero-risk investment is attractive. Long term, the curve is still inverted: the 3-month Treasury Bill is near 5.4% while the 30-year sits just below 4%. With the Fed still raising rates and short-term yields high, it’s hard to argue against short-term fixed-income securities. Opportunities are still present in longer-term investments, such as mortgage-backed securities, which are currently benefiting from a reduction in refinances.
Looking forward to the second half of the year, we remain cautious. A very small group of stocks have made up most of the gains in the market this year and the yield curve remains deeply inverted. M2 money supply is shrinking, and bank lending standards are tightening. Developed market central banks are still raising rates in a struggle to get inflation under control. Central banks have a history of being heavy-handed, and historically, a soft landing is not as likely as a recession.
The consumer has held up the economy so far, but discretionary spending levels continue to come under pressure. For all these reasons, we still favor large-cap value names over growth-, mid-, and small-cap. We’ve increased international developed equity exposure, as most have cheaper valuations, cheaper currencies, and will respond positively to a declining U.S. dollar. International equities also offer a higher yield compared to U.S. equities on average. As U.S. earnings expectations have been coming down, international earnings have been more resilient. We recently added active management in the U.S. large-cap value and international developed equity spaces. We continue to favor high-quality, short-term fixed-income investments, as it’s unlikely that the Fed is done raising rates. Our recent addition of mortgage-backed securities increased duration slightly, but we remain underweight compared to the index.
Remember that investing should be personalized to your long-term goals. While short-term markets may be volatile, we believe planning, risk management, proper asset allocation, and diversification are keys to long-term success.
Heather A. Voight, AIF® | Portfolio Manager
Previous market commentaries
2023 First Quarter Market Commentary 2022 Fourth Quarter Market Commentary 2022 Third Quarter Market Commentary
- Black Knight’s May 2023 originations market monitor. Black Knight® https://www.blackknightinc.com/data-reports/black-knights-june-2023-originations-market-monitor
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