SECOND QUARTER 2023 RECAP
As we look back at the second quarter of 2023, the most notable observation is what did not happen. In March, there was widespread concern across capital markets about the possibility of an extended banking crisis from the failures of Silicon Valley Bank and First Republic Bank. Quick action by the Federal Reserve and the U.S. Treasury calmed investors as the issues at those banks did not appear to be as widespread as originally feared. Attention then turned to the Federal debt and the possibility of the U.S. Government defaulting if the debt ceiling was not increased. Once again, the White House and Congress came to a last-minute compromise agreement, and new legislation was signed on June 3rd.
However, the biggest concern facing markets in the first half of 2023 was whether the U.S. economy would fall into a recession. Due to high inflation, the Federal Reserve increased interest rates beginning in the spring of 2022 and continued through the first several months of 2023 as they began a campaign to lower the inflation rate by slowing down the economy. Additionally, the Federal Reserve has been engaging in “Quantitative Tightening” by letting securities run off their balance sheet, which should further slow the economy by draining liquidity.
Despite these actions by the Federal Reserve, coupled with the concerns about a banking crisis and debt default, the U.S. economy proved resilient. GDP increased by 2.0% in the first quarter of 2023, unemployment remains low and job growth continues. We are still waiting for second-quarter numbers, but the current estimates are that GDP will be up another 1.11. While CPI figures announced in July were encouraging, Core CPI remained at 4.8% on a year-over-year basis, suggesting that inflation remains a problem. Most market participants now expect the Fed will raise rates at least two more times during the second half of 2023.
The resilient economy, and the optimism the Fed might engineer a “soft-landing,” fueled a first-half rally in U.S. stock markets. The S&P 500 finished the first half of the year up 15.9% and the Nasdaq was up 31.7%. Longer-term interest rates were flat for the first six months of the year. The U.S. 10-Year yield started the year at 3.879% and ended June at 3.837%.
Although equity market performance was impressive, it must be noted that performance was not broad-based as seven mega-cap technology stocks accounted for a significant amount of the growth. Optimism about an economic soft landing and, more importantly, excitement over Artificial Intelligence drove strong returns in these companies, including: Apple (+49%), Amazon (+55%), Alphabet (+36%), Microsoft (+42%), Meta (+138%), Tesla (+112%) and Nvidia (+189%). Without these seven stocks, the return of the S&P 500 would have been slightly negative for the first half of the year.
The economic picture for 2023’s second half is quite uncertain. There are indicators that suggest optimism, however, we note several worrisome trends:
- U.S. Unemployment remains low.
- Consumer spending has held up, particularly for service activities.
- Market volatility is near all-time lows.
- Global economic growth has remained surprisingly resilient with declining inflation giving the Federal Reserve the ability to pause its rate hiking cycle.
- Core inflation has come down from its highs following COVID but remains well above the Fed’s 2% target. Headline CPI fell to 3.0% in June while the Core CPI rate was 4.8%.
- Leading Economic Indicators have declined for fifteen consecutive months.
- M2 money supply is down 4% year-over-year due to quantitative tightening. This is the biggest drop in the money supply since the Great Depression.
- The U.S. Treasury yield curve (2-year vs. 10-year) remains deeply inverted.
- Global central banks continue to raise rates to combat inflation with the Federal Reserve indicating at least two more increases before year end.
- Strong gains from a small number of U.S. mega-cap technology stocks have increased concentration in broad indices, presenting risks if sentiment towards those companies were to reverse.
- The macro environment remains uncertain and the strong rally in global equity markets has pushed valuations higher than their long-term averages.
- The U.S. Supreme Court’s rejection of the Biden Administration’s plan to forgive student loan debt could cause a decrease in discretionary spending as debt service for student loans restarts after a three-year freeze.
- Higher interest rates underscore an often-overlooked fiscal challenge as it will substantially increase the cost to service the U.S. debt, which now stands at approximately $32 trillion.
Many economists and market strategists have been predicting a mild recession for at least the last year. At a conference of global central bank leaders last month in Portugal, U.S. Federal Reserve Chairman Jerome Powell commented that he was surprised at the resilience of growth in the U.S. economy. Monetary theory holds that the impact of changes in interest rates by central banks can have “long and variable lags” before they impact the economy. We are about 15 months into the Fed’s campaign to slow the economy by increasing interest rates and shrinking their balance sheet. Due to this lag, the impacts may start to be felt more strongly in the second half of 2023.
Given the above discussion, we feel there are ample warning signs for investors to be cautious. Our advice continues to focus on the core tenants of our investment philosophy:
- Maintain Asset Allocation discipline – Clients that deployed new cash or rebalanced their portfolio into equities at the beginning of this year might now be overweight in their equity targets. Continuing to re-balance back to target allocations is an effective way to manage risk.
- Invest in assets where valuations are attractive – U.S. Large Cap Growth equities are ahead of their Value counterparts by almost 24% YTD and have outperformed International equities by nearly 20%. Maintaining exposure to international equities is appropriate in our view given international developed and emerging market equities values are more attractive due to their reasonable valuations.
- Manage cash wisely – Investors can now earn nearly 5% in short-term U.S. Treasury money market funds. It does not make sense to leave excess cash in low-yielding bank accounts when highly liquid money market funds are available.
- Don’t Fight the Fed – We will continue to monitor the Fed’s actions and the impact of Fed policy on interest rates and markets. However, if they tighten more aggressively than what the market is pricing and the economy falls into recession, we anticipate new opportunities available in Alternative Investments that historically have benefited from economic turmoil. Some possibilities include:
- Private Equity Secondaries funds – These funds buy private equity partnership interests from other investors that are forced to lower their holdings or need to raise cash for personal reasons. Skilled managers seek to buy these private equity interests at substantial discounts.
- Distressed Opportunity funds – These funds look across capital markets to invest in the debt or equity of distressed companies as they restructure their business. Recessions typically provide more investment opportunities for distressed investors.
- Private Credit – With many banks pulling back on their lending appetite, private credit funds have been filling this void by lending directly to companies and many times at higher interest rates.
 “The Conference Board Economic Forecast for the U.S. Economy,” July 12, 2023, The Conference Board
The material has been gathered from sources believed to be reliable, however BWA cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Market index information, where included, is to show relative market performance for the periods indicated and not as standards of comparison, since these are unmanaged, broadly based indices that differ in numerous respects from the composition of Bordeaux’ portfolios. Market indices are not available for direct investment. The historical performance results of the presented indices do not reflect the deduction of transaction and custodial charges, or the deduction of an investment management fee, the incurrence of which would decrease indicated historical performance. The S&P 500 Index includes 500 leading companies in the US and is widely regarded as the best single gauge of large-cap US equities. The Barclays Capital U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar denominated, fixed-rate taxable bond market. The Russell 2000 Index is comprised of 2,000 small-cap companies and is widely regarded as a bellwether of the U.S. economy because of its focus on smaller companies that focus on the U.S. market. The Nasdaq Composite Index is an index of more than 3,700 stocks, weighted by market capitalization. This information may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those discussed. No investor should assume future performance will be profitable or equal the previous reflected performance.
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