Just like that…we’re halfway through another eventful year in the markets!
The longer we get to do this, the less things surprise us. This year has been a fresh reminder that behind the economic data and earnings is a whole host of human beings making investment decisions based primarily on two emotions: Fear & Greed.
Global equities seem to have decoupled from a worsening economic backdrop, prompting warnings from some of the world’s top money managers that chasing the rally from here could be a risky move. Growing corporate profit warnings are also flashing a warning sign. 1 Despite all of this and the most aggressive Federal Reserve interest rate hiking campaign in the history of the central bank, stock indices rose in the first half of the year. The tech-dominant Nasdaq 100 surged higher through June, recovering much of its losses from 20221, on the back of the AI hype-train. The S&P 500 also charged higher, but under the surface, just 7 companies were responsible for almost 90% of its gains.[1] The Russell 2000, a proxy for small-cap companies, also posted a modest gain through June.
On the fixed income front, yields on the short-term 2-year US Treasury have risen to levels not seen since 2006.1 This comes on the back of the closely watched benchmark 10-year yield not rising near as much or as fast. The shorter-term issue yielding more than the longer-term 10 year has created an inverted yield curve at levels that have foreshadowed recessions in the past. We’re watching the bond market closely as never in history has the stock market bottomed before the start of a recession. On the positive side, it has been a long time since investors could be paid as much interest for being patient and waiting in short-term bonds backed by the full faith and credit of the United States government.
Commodity markets continue to point to a worsening global economic backdrop. Oil posted its longest run of quarterly losses in data going back more than three decades1 amid robust supplies and persistent concerns over demand. Oil has faced worries about a potential global economic slowdown as well as a lackluster recovery in China. Robust crude exports from Russia and Iran have kept supplies ample, outweighing a potential pickup in summer demand and production cuts from the Organization of Petroleum Exporting Countries.
With all the hype and mixed emotions swirling around markets we believe the following points are critical to keep in mind moving forward:
- Equity valuations at large are high relative to history1 and notably high when compared against the “risk free” rate offered in ultra-short duration US Treasuries. This puts more emphasis on corporate earnings as many mega size companies will need to live up to recent hype around future growth prospects, especially those that are connected to “Artificial Intelligence”.
- US Corporate bankruptcies are on the rise1 and the cost to refinance debt over the next year or so will at large be more costly than at any point in roughly two decades. The last two cycles saw this dynamic resolve in a beneficial way for stock prices only when the Fed Cut interest rates.
- Recent headline strength in the labor market relative to consensus expectations along with inflation that remains above the Federal Reserve’s stated target will make it difficult for the US central bank to aggressively cut interest rates. We believe resurgent inflation remains a risk for monetary policymakers and that the stock market might need to adjust to higher for longer rates.
Rarely in the history of investing could one find a time where the economic backdrop and stock price action have been so strongly opposed to one another as in the first half of 2023. We’re leaving the debates of whether this is in fact a new bull market and how much recession risk is ahead to the pundits. Instead, we’re going to continue to adjust based on our data-driven process which has helped us navigate treacherous markets for a long time. As such, we continue to hold a slight under-allocation to equities tilt within our investment strategies. We’re taking advantage of the opportunity presented with short-term US Treasuries for our clients. If economic data starts to improve and the earnings season shows Corporate America & the consumer are staying resilient, there are many relative value areas of the global markets we have our eyes on that could catch-up a great deal. Our defensive tilt helped us tremendously from the end of 2021 through the first 3 months of this year and we believe it remains prudent until the fundamental picture improves notably. We remain flexible and ready to act when the data points to there being stabilization in the global economy. Until then, we’ll continue with our focus being heavily slanted towards risk mitigation vs possible loss of short-term trading profits.
Ryan A. Mumy, CFP®, AIF®
Chief Investment Officer
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