By Daniel McGarvey, Portfolio Analyst
2023 has continued to be an impressive year for the capital markets despite monetary tightening, banking woes, U.S. default concerns and mixed economic data. The S&P 500 had its best first half since the 1980s with 16.9% returns, although the equal-weight index only returned 6%. The Bloomberg Aggregate Bond Index rose 2.1% as the 10 Year Treasury Rate rose to 3.8%, and high-yield credit spreads tightened to 4.1%.
The Federal Reserve made an interesting move in June by unanimously choosing to refrain from raising rates while also signaling two more quarterly hikes to come later this year. This leaves the Federal Funds Rate in the 5-5.25% range after beginning the year at 4.25-4.5%. Futures markets are expecting one more hike, but we would not be surprised if they follow through with more than one due to a stronger economy and stickier inflation than expected. Ultimately, the Fed still has to decide whether it prefers the risk of letting inflation reignite or the risk of tightening to painful levels. The decision is even harder since 2024 is an election year, and any move could be seen through the prism of political bias.
A recession could potentially tempt Chairman Powell to loosen prematurely, although many are beginning to doubt whether this widely anticipated recession will arrive after all. Headlines have been less pessimistic, consumer sentiment is increasing, and equity markets have been acting like we’re in the clear. Some important points that seem at odds with a bull market, however, are that the unemployment rate is low, the yield curve is sharply inverted, and the money supply has fallen substantially. Some sectors, like housing, manufacturing and banking, have already weakened, but the labor market looks like it typically does late in a cycle. In our opinion, we still cannot count out the possibility of a recession in the next months or year until there is confidence that inflation is anchored. If we do have a soft landing, it will likely require the Fed declaring victory at an inflation level closer to 2.5-3% than 2%.
Along with hiking rates, the Fed has been engaging in quantitative tightening by letting its balance sheet roll off. Its shrinking balance sheet is no longer being offset by injections from the Treasury General Account (TGA), so the tightening effect should now start to actually be felt. The tightening, combined with new debt issuance to reload the TGA, has drained liquidity from the system and will likely continue to do so in the coming weeks and months. The drain will be exacerbated if the Treasury debt issuance is funded mostly through bank reserves, and it could be a headwind both for banks and for higher beta stocks. The NASDAQ will often lag the S&P 500 when liquidity is squeezed out (see chart below).
Banks are expected to face growing capital scrutiny despite their positive recent stress test results, along with potentially facing increased supervision from the Fed. Although these heightened requirements are intended to add stability to the financial sector, they might aggravate credit concerns. The largest banks seem less vulnerable, but proposed changes could significantly impact the profitability of regional banks that are already rationing credit. Further rate hikes could also squeeze out some smaller players if they keep struggling to attract high-quality deposits.
While financial stocks have struggled to recover all year, the shining stars have been technology and communication stocks, especially those tied to artificial intelligence (AI). It could even be argued that the revolutionary potential of AI is what has propelled markets despite the other macro headwinds. The hope is that AI will be able to boost productivity, and it probably will, but the extent is unclear at this point, and AI stocks are already pricing in tremendous growth. The Biden administration is also proposing stricter export controls on certain AI chips, especially to China, which could curb growth.
Amidst the ongoing trade tensions with the U.S., China’s expected economic recovery seems to be losing momentum. Other major international powers are also facing some difficulties, such as the Eurozone, which continues to battle inflation and attempt to control energy markets. In Russia, the Wagner Group mutiny appears to have fizzled out, but we will continue to monitor since any major developments can have meaningful consequences for global energy supply. The second half of the year will demand that global policymakers and central banks make difficult decisions.
On the real estate front, housing activity weakened throughout the year but has now shown some signs of stabilization. Although rates are still high, home prices have decreased, permits have picked up, and new home sales surged a remarkable 12.2% month-over-month in May. We are still quite cautious on exposure to commercial real estate, however, which remains under heightened pressure due to restrictive lending terms from high rates and bank weakness. This will be a sector to keep an eye on if the Fed continues hiking.
In late June, the Supreme Court overturned President Biden’s student loan forgiveness plan, meaning that millions of Americans will have to get ready to repay their entire balances again. Although there are still some alternatives being proposed to decrease the burden for borrowers, payments are set to resume in October after a three-year pause. This will force households to reallocate their spending power, especially younger people (see chart below). The average monthly payment is $380, and borrowers who graduated since the pandemic have never had to make a payment, so the increased burden on consumers could exacerbate economic weakness in the coming quarters. Of course, loan forgiveness would have also had significant consequences by worsening the government deficit.
Investment Allocation
Despite the recent outperformance of high-growth names, we have not significantly changed our equity allocation. Perhaps even more than before, we favor value over growth throughout the cap spectrum, especially with an emphasis on high-quality dividend growers. We continue to be concerned about the concentration risk of the market and think that valuations look more attractive in some asset classes that have been neglected.
International and emerging market stocks continue to trade at desirable valuations, but there is still heightened uncertainty given the ongoing threat of war and geopolitical tension. As such, we maintain our positive long-term view and cautious near-term view.
With our belief that there could be more rate hikes to come, we are continuing to keep fixed income duration shorter than the benchmark. However, we plan to gradually start adding on some duration as the risk/reward profile becomes more palatable. We also continue to prefer high-quality bonds until we see credit spreads widen.
As we have been all year, we are also in favor of holding alternative asset classes that can offer diversification and uncorrelated sources of return in times of uncertainty.
*Charts provided by Strategas Research Partners, LLC.
Material discussed is meant for general/informational purposes only and it is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary, therefore the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss. The opinions and forecasts expressed are those of the author and may not actually come to pass. This information is subject to change at any time, based on market and other conditions.
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Daniel is a Portfolio Analyst at Stonebridge Financial Group and works on portfolio analysis and other related tasks. When away from the office, Daniel spends his time playing guitar, reading, and exploring the outdoors.