Market Commentary: Q2 2023
At a Glance
- Equity markets posted strong gains to end the quarter bolstered by solid economic growth
- Tech stocks were the clear winners in the first half, but breadth increased to end the quarter
- The Fed paused interest rate increases in June, but signaled more increases are likely
- The economy has resisted the recession forecasts of several indicators
Resilient Economy and Rebounding Markets
Investor sentiment was buoyed in the second quarter by economic activity that remains strong, signs of moderating inflation, and the first pause in the current interest rate cycle.
- Equity markets ended the quarter with solid gains that extended beyond the large technology leaders that had dominated earlier in the year.
- Interest rates remained in a relatively narrow range during the quarter, but did see some upward movement during the debt ceiling negotiations in May and in response to Fed chairman Powell’s comments at the end of the quarter that several more rate increases were likely in the second half of the year.
- Despite the Fed’s aggressive efforts to slow the economy, current conditions remain solid with still tight labor markets and robust consumer spending.
- The fear of course is that the tighter policy so far (with perhaps more to come) will eventually lead to a recession and a sell-off in risk assets.
Equity Returns: Q2 and Year-to-Date 2023
Stocks continued to rally in Q2
- The NASDAQ led the way, rising 15.01% for the quarter and 32.32% so far this year, the highest first half return since 1983 and far outpacing other indices. 3
- The dominance of the mega cap tech companies eased somewhat to end the quarter, with the top 44 stocks accounting for all of the broader equity market gains in June compared with just 8 stocks in May. 4
- For the quarter, the S&P 500 index was up 8.74%, pushing the year-to-date return up to 16.89%, its best first half since 2019. 5
- Despite solid June returns, the Dow continued to lag other indices, rising 3.97% for the quarter and 4.94% for the year so far. 6
- In the US, small cap stocks rallied in June, but remained well behind the larger cap indices for the quarter and first half of the year. 7
- Equity returns outside the US, while positive, remain relatively weak.8
S&P 500 Economic Sector Returns: Q2 and Year-to-Date 2023
Market breadth across sectors also improved to end the second quarter with all 11 S&P 500 industry groups posting gains in June, compared with just 3 sectors in May and 8 in April. 9
- Technology stocks led the way for the quarter as they have so far this year with the Consumer Discretionary and Communications sectors not far behind. 10
- Energy and Utilities stocks were the laggards for the first half of the year and the only sectors to post negative returns for the second quarter.11
Fixed Income Returns: Q2 and Year-to-Date 2023
The Fed Hit the Pause Button in June
As expected, the Fed paused its rate increases in June, but debt ceiling uncertainties in May and Chairman Powell’s June 14th press conference comments that “nearly all Committee participants view it as likely that some further rate increases will be appropriate this year” caused interest rates to hold steady during the quarter. 12
Fixed income returns were mixed for the quarter, with returns for equity-like instruments (preferred stocks and high yield bonds) as well as short-duration bills and bonds faring best while intermediate bonds posted negative returns. 13
Still, the modest decline in interest rates so far this year has led to positive returns across all major fixed income segments during the first half of 2023.
Avoiding a Slowdown…So Far
The strong returns for equities and the most equity-like fixed income instruments so far this year reflects investors' focus on the still strong economic conditions. As we have noted in our prior commentaries, markets seem to be pricing in either no recession this year or at worst a “softish landing”. It’s hard to argue with the persistent strength in the economic indicators, especially the tight labor markets and modestly positive GDP growth. Still, the Fed’s perception that it has some work to do to bring inflation down to its 2% target as well as some weak forward looking measures creates uncertainty in the outlook for risk assets.
The most direct forecast of economic growth in the US is the Conference Board’s Leading Economic Indicator index (LEI). The most recent LEI release for May showed that the index had declined for the 14th consecutive month. 14 As the chart shows, the year-over-year change in the index has been negative for over a year, usually a sign that a recession is likely in the subsequent 6 months. This result is what we see in the 2001, 2008/9 and 2020 recessions, but we can also see that just touching 0, as the index did in 2003 and 2016 was not followed by a recession. What is interesting in the current episode, is that the LEI is sharply negative and has been falling for some time, long enough that a recession would have been expected to have started by now. The Conference Board still forecasts a recession, but has moved the date out to later this year or early 2024. The data in the chart also shows that the LEI can bounce back quickly. Indeed, any improvement in the current most negative components (credit availability, interest rate spreads, manufacturing new orders and consumer sentiment) could lead to a reversal in the index.
U.S. Leading Economic Indicator Index
The interest rate spread component of the LEI on its own is also a popular measure used to forecast economic activity. A negative spread between the 10-Year and 2-Year Treasury yields (an “inverted yield curve”) has often been associated with subsequent recessions. The chart below shows this spread going back to 1976 overlaid with recessionary periods in the shaded areas.15 Over this time period, the inverted yield indicator has accurately forecasted recessions, but the time lag can be variable. The current spread is as negative as it has been since the early 1980s, ominously another period where the Fed was aggressively determined to bring down high inflation. Still, many observers note that the current environment is very different from past periods and so the negative spread may not portend a recession. Usually “this time is different” justifications do not hold up well, but it is true that coming out of the zero interest rate policy period since 2008 combined with inflationary pressures from COVID related issues makes for a very different environment than the 1970s “stagflation” era.
Yield Spread: 10-Year Minus 2-Year Treasury Yields
Taken together, the usual recession indicators are still flashing red. Combining that with the strong and concentrated equity market gains so far this year and the Fed’s indication that rates are likely to rise further, makes for a great deal of uncertainty about the path for risk assets for the second half of the year. We can all enjoy the gains that are in the book so far in 2023, but should remain cautious in our expectations for the economy and the markets going forward.
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