A Possible Soft Landing
As we move into the latter half of 2023, the recession has yet to arrive. Several factors in the market illustrate the ongoing resilience of the U.S. economy:
- U.S. net monthly job gains are up, with 3.8 million jobs added over the past 12 months.
- The employment recovery is complete, and the total labor force is in excess of pre-pandemic numbers.
- While there is still a gap between supply and demand of labor, labor force participation by age demographic indicates a more optimistic outlook, with the core demographic (ages 25 to 54) close to a 20-year high.
- Consumer confidence has not returned to pre-pandemic levels but has climbed over the past several months.
- The Consumer Price Index (CPI) shows declining inflation over the past 12 consecutive months, especially in the food and energy baskets, which have been in deflation for the past four months.
- The “misery” index (CPI plus unemployment rate) is relatively low compared with the past decade.
Despite this, leading economic indicators (LEI) continue to show recessionary trends. With these conflicting indicators, the question of how the overall economy is doing becomes increasingly difficult to answer. If a recession does occur in 2023 or 2024, it will likely be a “soft landing” or spotty – milder, shorter, and/or affecting some parts of the economy more so than others.
What to Watch
Heading into the second half of the year, we are still focused on inflation, with the Federal Reserve watching core inflation closely. June inflation statistics show the overall CPI up 3%, with energy down 16.7% and food prices still up but moderated. Core inflation ex food and energy is up 4.8%; it will be important to watch the measure of shelter (which accounts for 35% of CPI) and whether it declines or increases.
Another key indicator of inflation levels and market health is consumer confidence. With student loan payments set to resume in the fall, there is speculation that growth in retail sales might suffer. They have climbed marginally since April 2023 but have not returned to early-2022 levels. Market expectations for second quarter 2023 corporate earnings growth predict 17% year-over-year growth, but it is too early to tell if this rebound will occur.
Finally, we will be watching the Fed’s response to slowing economic activity and this variable economic environment. The futures market predicts a 93% chance of the Fed raising interest rates one more time at its July 26 meeting by 25 basis points, and at present the market predicts that by July 2024, there will be enough progress on inflation to lower interest rates. At this meeting, be on the watch for whether or not the Fed acknowledges the economic headwinds or progress on the inflation front.
Market Returns for Q2 2023
Equity markets remain strong for the year to date period ending June 30, 2023, after a difficult 2022, with solid returns across equities of every style, geography, and market capitalization. The information technology sector reported particularly strong returns. Over the longer term, 10-year returns are positive for equities, with the S&P 500 returning 12.8%. Fixed income pulled back during the second quarter as the Fed raised rates and increased its terminal rates forecast, but returns remained positive year todate.
Unlike last year, Nasdaq is leading equities, while oil and commodities are negative. The declining performance of oil and commodities compared to 2022 illustrates the value of our investment philosophy: staying invested in what we believe will generate returns over long periods while avoiding the temptation to rotate into whatever is working at the moment.
In U.S. equities, the S&P 500 index (cap-weighted) outperformed the S&P 500 equal weight index, its strongest outperformance yet on an annualized basis. This is concentrated in mega-cap tech companies, which benefited from optimism related to artificial intelligence (AI), and sector winners so far year to date were laggards in 2022. Relative to the Russell 2000 (small-cap stocks), the market cap of the S&P 500 is at all-time highs.
In this environment:
- We are watching mean reversion risks for the S&P 500 as global growth declines and/or companies face earnings pressure.
- We want to continue to own equities, as our managers’ portfolios remain attractive.
- However, we recommend clients continue to rebalance portfolios back to targets at both the asset class and manager levels and diversify their portfolios.
Our portfolio has so far benefited this year from owning a number of tech company and quality stocks. Quality remains a key factor, as it outperformed the S&P 500 during the year. Finally, year to date, the S&P 500 has largely been immune to market volatility, with zero trading days of declines 2% or greater in the second quarter.
Developed international equities outpaced emerging markets equities, with Italy, Ireland, Spain, Germany, France, and Japan driving these results. In emerging markets, Brazil, Taiwan, and Mexico were top performers. China and countries within Asia-Pacific generated negative returns. Notably, Chinese internet stocks have not benefited from the tech-everything rally, indicating Chinese geopolitical risks are weighing on investor optimism.
During the quarter, yields moved sharply higher, with the yield curves remaining inverted – signaling that we are still waiting on a possible recession. Despite recessionary fears, however, credit spreads remain below the long-term average. Our policy portfolios don’t include high-yield allocations, but we do think there will be opportunities for some in the future. As the year continues, we will look to be nimble in the face of changing markets as new opportunities and risks present themselves.
BBH Portfolio Performance and Positioning
Our equity and fixed income portfolios have so far generated strong absolute and relative returns. Within public equities, our U.S. large-cap equity managers contributed solidly. Looking at fixed income, our portfolio continues to provide liquidity, stability, and meaningful yield as rates have increased dramatically. With privates, early signs point to additional uplift in the portfolios.
In the second quarter, we saw our 2022 decisions continue to pay off:
- We reaffirmed our public equity investment philosophy focused on high-quality companies. Last year’s losers are this year’s winners, with quality stocks leading the year-to-date rally and 2022’s worst performing managers being the top year-to-date performers.
- We continue to concentrate on the long term, staying focused on high-quality companies.
- We remained focused on the fundamentals of businesses, as ultimately that is what drives stock prices.
Looking at key market risks, our philosophy of investing bottom up and worrying top down remains true. Our Investment Research Group (IRG) is monitoring the following factors that may lead to heightened volatility in the near term:
- Concentrated source of market returns
- Downward earnings revisions
- Fed response to sticky inflation despite slowing real GDP growth
- Continued elevated core inflation globally
- Ongoing weakness in smaller regional banks and industries that may be affected by the banking crisis
- Geopolitical risks surrounding China, Taiwan, and Eastern Europe, as well as the impact of OPEC on oil markets
- The opportunities and risks of AI and machine learning
Our public equity portfolio remains overweight in developed markets, particularly the U.S. – offset by an underweight to emerging markets. Our largest industry underweight is the more capital-intensive tech hardware, while we are overweight in tech software. We also have a meaningful overweight to the financial services industry, but this exposure is not in banks.
As we look ahead at our portfolio positioning, we are:
- Focused on preserving capital in a challenging macroeconomic environment
- Focused on high-quality companies with pricing power that can protect against long-term inflation; valuation and strong fundamentals are critical to future success
- Maintaining a conservative short-duration posture in fixed income, but opportunistically adding to duration when the return compensates investors for the risk
- Adding a new internal private equity and co-investment fund that can take advantage of opportunities in its areas of expertise
- Recognizing the value of diversifying our portfolios
- Encouraging rebalancing back to target to ensure prudent risk management, given the strong run-up in equities
- Monitoring the potential new AI-driven supercycle in the market – and the opportunities and risks this tech poses
Overall, we remind our clients to focus on value, rather than price, as we expect the embedded value in our portfolios to be realized over the long term.
For more on recent market performance and our current portfolio positioning, stay tuned for IRG’s upcoming “Market and Portfolio Update Q3 2023.”
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