Tech Drives Equity Surge, International Markets Stay Positive, and Fixed Income Up but Subdued
The domestic equity market demonstrated strong performance in the second quarter of 2023, with the S&P 500 increasing by 8.74%. A familiar narrative emerged as the technology sector led the charge, with the tech-heavy Nasdaq posting its best first half of a year since 1983. Giants such as Apple, Microsoft, Alphabet, and Meta once again dominated performance, while the surging interest in artificial intelligence (AI) helped fuel returns as well. The consumer discretionary sector also stood out, bolstered by solid performance from Amazon, Lowe’s, and Home Depot. These companies have benefited from robust consumer spending and a more resilient economy than some had expected. In contrast, value stocks underperformed during the quarter. The consumer staples, utilities, and energy sectors saw negative returns, reflecting investors’ continued preference for growth over value.
Internationally, developed markets underperformed compared to their U.S. counterparts but remained in positive territory. The MSCI EAFE Index, which gauges the performance of developed markets outside North America, advanced by 3.19%, while the MSCI Emerging Markets Index, reflecting emerging markets’ performance, increased by 0.97%. The European Central Bank (ECB) raised rates twice during the quarter, both by 0.25%, in response to economic indicators. Meanwhile, the Bank of England adopted a more aggressive approach, raising rates by 0.25% in May and hiking by 0.50% in June.
Fixed income markets exhibited relatively flat performance during the second quarter. Municipal bonds generally outpaced corporates, and investors seeking yield found solace in lower-rated debt, with high-yield bonds outperforming their investment-grade counterparts. However, the general sentiment (and returns) in fixed income remained subdued. The U.S. Federal Reserve raised rates by another quarter point in May, bringing the benchmark rate range to 5% to 5.25%. Notably, signals from the Fed indicated that the cycle of rate hikes may be nearing its end, shown by the Fed’s decision not to raise rates in June for the first time in ten meetings. This comes as inflation, housing starts, and employment are moving in the right direction. Policymakers do still expect that they might need to raise rates again at some point to combat persistent inflation, though the central bank’s new policy will be more focused on assessing how the economy is reacting to recent changes before making further adjustments.
Outlook: Inflation, Consumer Economy, and the Fed
Looking forward, investors will be closely monitoring economic indicators and their impact on central bank policies and market dynamics. Inflation will remain the key data point here: the Consumer Price Index (CPI) has declined slowly but consistently, and how that data bears out will be the most critical determinant of the Fed’s course moving forward.
The consumer remains strong, but there are hints that the Fed’s tightening measures are beginning to have the intended effect. Delinquencies on credit cards, which have been historically low, have now returned to levels seen before the pandemic. Additionally, while wage growth remains high, it has been gradually softening since the beginning of the year, a trend that continued throughout the second quarter. Slower borrowing and a cooling labor market are important disinflationary factors for the Fed and will be key in the fight to finally tame inflation.
Financial Sector Resilience and Future Rate Speculations
Despite the U.S. central bank leaving the door open for additional rate hikes in the short term, the market is still holding onto the possibility of rate cuts by the year’s end. The persistent disconnect here should be resolved soon, and we are more inclined to believe the Fed’s dot plot, which indicates any rate cuts are still relatively far off.
As we expected, the turmoil that plagued the regional banking sector last quarter did not proliferate into other areas of the banking sector. The industry’s resilience can be attributed to robust capital levels and risk protocols at large U.S. banks. This was evidenced by recent annual stress test results released in June, where all large institutions received passing grades. While it is possible a new round of capital flight could cause issues for banks that are not as well-capitalized, balance sheets at systemically important institutions are strong and our base case is not for such problems to materialize.
Tech Sector Outlook: AI Investments and Market Breadth
AI became a focus for investors in the second quarter. While this technology has revolutionary potential, some caution is advised. The AI market is volatile, and some valuations have become quite stretched. We find it prudent to stick with established players like Microsoft and Alphabet in such an environment. Their scale provides them with a significant advantage in accumulating the data necessary to advance AI technologies. We are keeping an eye on the sector and may make a more targeted investment should one present itself, but are approaching investments in the space with our guards up.
We will also be monitoring the tech sector more broadly given the outsized moves in some stock prices in the sector year-to-date. While the historic outperformance in the Nasdaq is undoubtedly welcome, we will look to see other sectors catch up and provide some more breadth to the market. We were encouraged to see the consumer discretionary sector contribute notably to Q2 returns as well and would view any additional broadening of the equity market as a further positive.
China Outlook and Market Resilience
On the international front, China’s economy has shown some red flags shortly after its post-Covid reopening had started to provide a boost to global trade. Manufacturing has contracted for three consecutive months, job shortages for young people have emerged, and the country’s property market has once again raised concerns. The Chinese government is typically willing to provide stimulus to bolster growth in these situations, though we will continue to monitor the situation and its impact on the global economy.
Compared to Q1, the second quarter tracked some similar patterns but saw fewer extreme events. Security performance during Q2 was strong, and the underlying economy has held up well. Despite the challenges and headwinds discussed, equity markets remain resilient, and we maintain a pragmatic but positive long-term outlook.