Quarterly Commentary

2Q 2023

Despite the Federal Reserve’s efforts to cool things down, both the economy and stocks have exceeded expectations so far in 2023. Chastened investors were apprehensive after both stocks and bonds registered double-digit declines in 2022, their worst combined performance on record.

Entering 2023, two issues were top of mind: When would the Fed pivot from the inflation fight by reversing course towards less restrictive monetary policy? And would the pivot come soon enough to facilitate a soft landing or would the Fed turn the interest rate screw too many times and trigger a recession? Forecasts for 2023 market returns were focused on whether the Fed could manage to time the pivot just right.

Six months later and we’re still looking for answers. It’s not that nothing happened – far from it! Keeping an eye on economic indicators, the Fed continued raising rates; most recently in May. They skipped June, prompting a sharp but brief rally in riskier assets, as some investors anticipated that the pivot had arrived. But it didn’t take long before Fed Governors signaled that a rate hike in July is highly likely, and the rally fizzled.

Inflation is complicated, as are the metrics used to track it. The most comprehensive (known as all-items) version of the Consumer Price Index (CPI) rose 3.0% over the twelve months ending in June, down from 9.1% a year ago. Stripping out the volatile food and energy factors, the CPI rose 4.8% over the last twelve months, slower than the 5.9% rise registered a year ago. Housing costs – what you pay in rent, or what you would pay if you were renting the home that you own – constitute one-third of CPI. It takes a full year for housing inflation to be fully reflected in the CPI. With housing inflation at 7.8% year-over-year but finally moderating, it seems as though inflation is on track to slowly return to the Fed’s 2% goal.

So why is the Fed still talking tough about raising rates? First – in order to influence expectations. The Fed wants consumers and businesses to believe that it will do whatever it takes to tame inflation and to act accordingly.  Second – due to concern about the labor market. There are simply too many jobs and not enough workers. If businesses pay up to fill openings, they will raise prices and those new employees will have more money to spend – the ingredients for a wage-price spiral. The main drivers of this dynamic are an overheated (in the Fed’s opinion) economy and an aging out of the Baby Boomer workforce (at a greater rate than Gen Z entrants). While the labor market is rebalancing slowly, the problem of an aging workforce is not going away (though is much worse in China, among other places). Carefully crafted immigration policies and increased productivity via automation and other “smart” technologies will be crucial to dealing with this over the long run.

With the Fed raising rates, war in Ukraine, and a regional banking scare, how did stocks hold up so well? Simply put - each episode triggered selling by the fearful, which attracted price-conscious buyers. Then as the worst (economic) fears were not realized and prices were rebounding, those who had sold were looking to get back in the market, driving stocks even higher.

Underlying the market recovery were notable performance disparities within the stock market - you may recall having heard this story before. Over the course of the second quarter, US stock indexes were increasingly driven higher by a handful of companies, this time amid enthusiasm over the potential for widespread adoption of generative Artificial Intelligence (AI). The frenzy was partially triggered by ChatGPT, a “model” trained to have conversations with users. While it launched in November of 2022 (when it took just five days to reach one million users versus Netflix – 3½ years, Facebook – 10 months, and Spotify – 5 months), it hit the mainstream earlier this year and ignited people’s imaginations about all of the possible use cases.

As of June 30th, the seven largest stocks constitute 28% of S&P 500’s value (23.7% of the Russell 3000, which includes 2,500 more companies, albeit much smaller ones). Returns for the seven year-to-date: Apple - up 50%, Microsoft – up 43%, Alphabet - up 36%, Amazon - up 55%, Nvidia – up 189%, Tesla - up 113% and Meta – up 138%.

It’s worth repeating the dominant narrative surrounding these names. They are “safer” to own because they:

  • have strong balance sheets and generate impressive cash flows.
  • provide important daily-use services and are growing faster than the economy.
  • maintain healthy margins, in part due to the benefits of scale.
  • are all perceived to be tied to AI, either directly or indirectly.

We agree with nearly all of this. However, trees don’t grow to the sky. Everything has a reasonable valuation, even the market’s darlings. If investors are piling into these “safe” stocks because they believe the prices will always rise, we urge caution (in 2022 all of them underperformed). A large swath of the market is trading near recessionary valuations, and we generally see more interesting opportunities there. While we maintain diversified exposure (across sectors and geographies) in our strategies, we are positioned for the performance disparity to narrow, either as the broader market rallies to catch up to the big tech, or as the current leaders falter and the broader market proves to be more resilient.

Hopefully, the second half of this year will provide clarity on the two biggest issues facing the US economy: when will the Fed pivot and will it cause a recession? Ideally, we will see rates stop rising and the economy muddle through, but we’ll do our best to be prepared if it doesn’t work out that way.