Halfway through the year, equity markets have produced very compelling returns. Defined benefit plans with higher allocations to equities have had a good six months. And thinking about our theme of “recession or recovery” in the second half, the stock market isn’t showing signs of concern, but as you well know that can change at any moment.
Risk assets
Picking up where we left off at the end of the first quarter, it was another strong quarter for Risk Assets.
Large cap: The magnificent seven
US equities produced another quarter of strong results in Q2. Large Caps led the way thanks to the so-called “Magnificent Seven”, familiar names like Microsoft, Google, Amazon, and Apple. In the 1960s and 1970s, these companies would have been “one-decision” stocks because buying them was the only decision investors needed to make. These are companies with strong fundamentals and growth prospects. There seems to be a perception amongst investors that these mega-cap companies are so pervasive and entrenched in our economy that they have become required core holdings. Certainly, the emerging awareness of AI had something to do with the perception surrounding these companies.
Small cap: Much better
Interestingly, Small Cap stocks performed quite well in the second quarter, much better than they did in the first quarter. Typically, Small Caps lag heading into a recession, which tells me that the stock market isn’t concerned about an economic slowdown at this point.
Non-U.S. developed equities: The comeback trail
Non-US developed equities generated solid performance, especially in local currency terms. This occurred despite lower growth and higher inflation than we’re experiencing here in the US. And because Non-US developed markets have less concentration in technology stocks than we do, their markets were driven by other factors, including value investing, which is staging a comeback in Japan. Emerging Markets, on the other hand, were a bit of a disappointment due largely to China’s lackluster post-Covid recovery. China comprises more than 30% of the EM index, so it has an outsized influence on returns.
Fixed income: Headwind or tailwind?
On the fixed income side, it was generally a difficult space in the second quarter. Investment grade corporates, both intermediate and long, lost money as rates edged slightly higher, but credit spreads did not tighten enough to offset that impact. High yield, which is driven mainly by credit rather than rates, turned in a good quarter and is having a solid year. The good news for bond investors is that yields remain rather attractive.
Market and economic influences
As I always say , I don’t know where markets will go from here. The best that I can do is identify some of the key areas influencing markets and the economy and think through the probabilities. The most important job for investors is to put together a thoughtful plan upfront.
Corporate earnings: Holding their own
The first area is corporate earnings. In the long run, earnings drive stock prices, but over short time frames, price multiples can have more sway over prices. Over the course of this year, analysts’ earnings estimates have come down slightly, but not dramatically. Equity analysts are still predicting double-digit earnings growth for the S&P 500. Now, whether that earnings growth will be sufficient to support another six months like we’ve already experienced this year is open for debate. But the point is, corporate earnings are holding up. From the perspective of corporate earnings, equity analysts aren’t signaling recession just yet.
The Fed: The elusive soft landing
Undoubtedly the Fed has played a significant role in the direction of markets over the last decade. It will have a lot of influence on whether we a recession has been raising rates over the last year in an attempt to slow the economy enough to tame inflation without bringing it crashing down – the elusive “soft landing”.
Interest rates: The end of cheap money?
The Fed’s own members have reset their views about interest rates regularly over the course of the last year. A year ago, Fed members predicted Fed Funds would top out below 4% in 2023. Now, they think short rates will remain above 4.5% through next year. Your guess is as good as theirs.
Yet, in spite of the Fed’s poor record of predicting the level of interest rates accurately, markets still pay close attention to each Fed speech and statement because interest rates can exert a powerful influence over our economy. We saw that in the first quarter when several regional banks went under due in part to higher interest rates. Just this week transportation company Yellow filed for bankruptcy. Money is no longer cheap. One wonders how many other companies are suddenly finding it more difficult to get financing. t’s no time to be complacent about rates and the Fed because the job’s not done.
Inflation: The vampire slayers
In nearly two years, inflation has climbed by more than 500bps. Even though it’s tracking down this year, inflation is still quite far from the Fed’s target of 2%. The Fed wants to avoid the scenario we talked about last quarter: a rebound in inflation. Like the ending of every horror movie, you can’t turn your back on inflation until you’re sure it’s dead.
Heading into this year, many economists were predicting our economy would be in recession at some point. The inverted yield curve, declining PMIs, rising interest rates, and low consumer sentiment all seemed to point toward recession. Now there’s a sense that we’ve either pushed it off until next year or simply moved past it. Fortunately, the US consumer has remained strong. Low unemployment, wage growth, and the remnants of those stimulus checks have carried the day thus far. As long as we feel secure in our job prospects, we’re more likely to spend on dinners, vacations, appliances, and perhaps even the Barbie movie.
The bottom line
The bottom line for investors is not to get caught up in the short-term. Have a plan. Stay disciplined and focus on your long-term strategy. There will certainly be challenges and unknown unknowns lurking along the way, but as Yogi Berra said, “if you don’t know where you’re going, you’ll end up someplace else.”
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