Summary, Second Quarter of 2023:
The U.S. Federal Reserve (the Fed) largely completed its rate-hiking effort during the second quarter, although there is the potential for smaller rate hikes in the months ahead. Inflation, while still high, has been decreasing consistently as monetary policy continues to tighten and bank lending standards grow more restrictive. The banking crisis abated after a scare earlier this year, which significantly impacted stocks in the financial sector. In addition, supply chain pressures have eased and may potentially become deflationary, which should help the Fed’s fight against inflation. The stock market rallied during the quarter and may have gotten ahead of itself but remains in fair valuation range.
The economy continues to normalize as the Fed tightens monetary policy in an effort to slow inflation. The Fed’s efforts largely have worked, but they may not be finished yet. The futures market expects one more rate hike, then a pause, then the beginning of a rate-lowering regime. For now, inflation is coming down but is still too high for the Fed to start lowering rates, and unemployment remains stubbornly low. Meanwhile, not only have supply chains healed, but supply chain pressure is actually positive—meaning supply chains now may be a source of deflation. Lastly, for the broader economy, there has been some worry that excess savings will run out, which could tip the economy into a recession. We don’t agree with that line of thinking for two main reasons. First, the personal savings rate has actually increased this year. Second, baby boomers—who eventually must spend/bequeath their retirement savings—have built a collective nest egg of up to $70 trillion according to the Wall Street Journal. That is a massive amount of money that will help to cushion the impact of a potential recession.
Stocks—especially “growth” stocks—rebounded well during the second quarter as market participants expected a slowing of monetary tightening and advancements in artificial intelligence (AI) excited investors. While earnings estmates have been slowing, the slowdown hasn’t been as drastic as some projected. This is a bullish sign for future corporate earnings. It has been a respectable year for growth-oriented stocks, while dividend paying “value” stocks have lagged. Some of value stocks’ underperformance is due to the banking crisis, which hurt financial stocks—historically a consistent provider of dividends. In addition, as the business cycle continues to evolve and the stock market remains ahead of the general economy, market participants have shifted toward growth stocks versus slower-growing dividend payers. Meanwhile, bond yields have increased, giving investors the ability to invest in short-term instruments paying yields comparable to dividend-paying stocks.
The bond market appears to have hit a bottom and has started to claw its way back. The Fed’s monetary tightening has increased short-term interest rates, which has made money markets and other safer, short-term bond investments attractive relative to stocks—something we haven’t seen in a long time. At some point, the Fed will start to lower rates, which will cause bond yields to drop and bond prices to increase (bond yields and prices have an inverse relationship). Therefore, while bond yields are higher today, total returns in fixed income may be trending toward long-term averages, which should help reduce overall portfolio risk. Of course, all of this assumes that the Fed stays the course. If so, a normalization of the economy is likely, which is good for all market participants. We expect smoother sailing ahead, but first we have to get out of these rough waters.
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