July 21, 2023

Financial markets can be full of surprises. Some provide valuable information by which we might adjust our investment strategies. Other times, surprises can be a kind of noise that is best ignored. The U.S. stock market threw a party in the first half of 2023. Surprise! It was, however, a rather exclusive party. The tech-heavy NASDAQ Composite Index returned 32% for the first half, while the Dow Jones Industrial Average returned 4.9%. At 16.9%, returns for the S&P 500 Index came in second place. Interestingly, the ten largest S&P 500 companies generated 77% of the first half gain in the index—one of the narrowest rallies in stock market history. The last 18 months could be compared to a seesaw, as most of the very large technology companies have dominated so far this year after experiencing a difficult 2022. Just five companies currently represent over 24% of the value of the weighted S&P 500 Index. The S&P 500 Index is not providing the diversification it has historically; consequently, we are looking for investment opportunities away from the concentrated names.

Interest rates around the globe are again on the rise. Again, surprise! The yield on the 10-year U.S. Treasury, which serves as a benchmark for many asset classes, is just over 4% and closing in on last year’s high. Its real yield (interest rate minus inflation) is hitting new cycle highs. Historically, yields tend to peak after inflation peaks. Price inflation (CPI) reached 9% in the U.S. last summer and has been slowly trending lower since, requiring interest rates to remain higher for longer, with yields on 3-month to 2-year U.S. Treasuries all over 5%.

A significant portion of the decline in inflation rates over the last year can be tied to a material decline in energy prices. Lower energy prices are flowing through to lower goods prices as well. Inflation in the service side of our economy has been sticky, and, with this, higher wage inflation continues to be a concern for many businesses, organizations, and the Federal government. As we have previously observed, the global economic conditions supporting lower wages have changed. Tighter labor markets here and abroad have significantly improved the bargaining power of workers.

Another notable surprise in the first half of the year was an anemic economic bounce following the Chinese government’s decision to lift its stringent Covid lockdown policies. As China is the manufacturer to the world, weak growth in that country could be evidence of economic weakness globally. The U.S. economy has been growing at a suboptimal pace for the last few quarters, but the anticipated recession has yet to be recognized. After a short reprieve due to the banking crisis in the spring of 2023, the U.S. Federal Reserve is again tightening monetary conditions. We hope the Fed can control inflation without pushing the economy into a deep recession.

As a result of the Fed’s efforts, the fixed income market has become significantly more attractive, with yields exceeding 5% in many areas while inflation continues to fall. After ten years of minimal fixed income returns, today’s opportunities offer investors attractive income streams. Our strategy is to take advantage of these rates, locking some in for longer periods. This is timely because, by all indications, the Fed is near the end of its tightening cycle and rates typically come down in the months and quarters that follow a rate peak.

The economic backdrop that supported the trends of the last 20 years has changed. Supply chains are evolving, and geopolitical unrest is raising uncertainty and costs for businesses. We believe it’s against this backdrop that our strengths can shine. As fundamental analysts, we conduct the diligence necessary to identify companies – many of which are far from household names – that can not only survive more challenging conditions but can extend their lead over peers. As you’ve heard us say before, it’s not enough to identify the highest quality businesses; we must be judicious in what we’re willing to pay. The upshot of recession-induced bear markets is that they present opportunities to acquire compelling companies that are sold off with the rest of the market. We look forward to taking advantage of such opportunities while anticipating that many of today’s most valuable and celebrated companies may not remain the leaders of the pack.

It has been a turbulent period since the top of the market in January of 2022. Our patient approach has provided relatively stable returns, as one would expect. Still, the volatility has been unsettling. We appreciate the confidence our clients place in us and look forward to helping them make sound investment decisions over the coming months and years.

The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.

Stay Connected