Client Letter | 3Q 2023 Recap & 4Q 2023 Outlook
Key Updates on the Economy & Markets
Stocks and bonds were both impacted by a chain of events during the third quarter. It started with rising oil prices, which caused inflation to re-accelerate in August. The rebound in inflation contributed to a sharp rise in interest rates, with the 10-year Treasury yield rising above 4.50%. The rise in interest rates pressured stock market valuations, and the S&P 500 finished the third quarter with a -3.2% return. This letter recaps the third quarter, discusses the rise in oil prices and interest rates, and looks ahead to the fourth quarter of 2023.
Rising Oil Prices Reignite Inflation Fears
After trading lower during the past year, oil prices rose to a 12-month high during the third quarter. Figure 1 shows oil ended September above $90 per barrel after starting the quarter near $70. The steady climb in oil prices was attributed to a continued mismatch between demand and supply. Oil demand remains strong as the global economy continues to grow, while OPEC recently agreed to extend its production cuts through the end of 2023. Additionally, the US’s Strategic Petroleum Reserve sits at its lowest level since the 1980s, which leaves little capacity to mitigate potential supply disruptions. With OPEC’s production cuts squeezing global supply, oil prices surged nearly 30% in the third quarter.
The rise in oil prices caused inflation to re-accelerate in August, with gasoline prices accounting for over half of the monthly increase. While the rebound in inflation was widely expected, it focused attention back on the threat of persistent inflation. Oil’s use as a transportation fuel means that it touches nearly every aspect of the economy, and a continued rise in oil prices could keep upward pressure on inflation as rising fuel costs are passed through to the end consumer. Inflation pressures have declined significantly during the past year, but as the recent rise in oil prices shows, the risk of inflation flare-ups remains high.
Treasury Yields Rise Sharply in the Third Quarter
The prospect of renewed inflation contributed to the rise in interest rates during the third quarter. Figure 2 graphs the change in various Treasury yields from June 30th to September 30th. On the left side of the chart, the yields for maturities of two years or less were relatively stable. These short-term yields are highly sensitive to Federal Reserve policy, and the Fed’s only action was a 0.25% interest rate hike at the July meeting. Moving to the right, you’ll notice a sizable increase in yields on longer-maturity Treasury bonds. The 7-year yield rose 0.64% during the quarter, while the 10-year and 30-year yields both rose by more than 0.75%. The sharp rise in yields was
What led to the rapid rise in Treasury yields? One contributing factor was the surge in oil prices and subsequent increase in inflation. Throughout the first half of 2023, investors believed that falling inflation would result in fewer interest rate hikes by the Fed and potentially quicker interest rate cuts. However, with the economy remaining stronger than expected and oil prices rising, there is a growing realization that the Fed may need to keep interest rates higher for longer to prevent inflation from becoming entrenched. The recent rise in yields indicates the market is preparing for a longer period of higher interest rates and fewer near-term rate cuts. Another contributing factor was the increased issuance of Treasury bonds. Following the debt ceiling resolution in May, the Treasury Department can now issue more bonds to fund the growing U.S. government deficit. Treasury bond issuance is forecast to increase in the coming quarters, and investors are concerned that the surge in supply will outpace investor demand and cause bond prices to decline.
Consumers Face Higher Borrowing Costs
The stacked charts in Figure 3 show the Fed’s series of interest rate hikes have led to a sharp rise in borrowing costs. The top chart shows the interest rate on a 48-month auto loan has risen from 4.6% at the end of 2021 to 7.6% at the end of June. The middle chart shows the average 30-year fixed-rate mortgage rose from 3.8% to 7% over the same period. The recent rise in Treasury yields pushed mortgage rates above 7.30% during the third quarter, which implies that interest rates on auto loans also increased over the past few months.
The bottom chart illustrates how the rise in mortgage rates has impacted the homebuying process. According to the National Association of Realtors, the monthly house payment has risen from $1,249 at the end of 2021 to $2,052 at the end of June. Factoring in the rise in mortgage rates during the third quarter, the current monthly house payment is likely even higher. While many homeowners locked in low mortgage rates during the past few years, today’s homebuyers are navigating a combination of higher mortgage rates and home prices that are still elevated.
It’s not just homebuyers and consumers who face higher borrowing costs. Borrowers of all types, including businesses and commercial real estate owners, are adjusting to a new world with higher interest rates. For some borrowers, the math of higher monthly payments doesn’t work like it used to when interest rates were lower during the past decade. The looming question is whether borrowers can manage the increased interest rates and maintain their payments.
Data already indicates consumers, businesses, and commercial property owners are feeling the stress of higher rates. The percentage of auto loan delinquencies, which is defined as loans 90 days or more overdue, is rising across every age group, and there is a similar trend in credit card delinquencies. The rising number of Chapter 11 bankruptcy filings suggests businesses are also feeling the effect of higher rates, while some commercial real estate owners have made the strategic decision to hand keys over to lenders rather than invest more money in undesirable buildings. These early signs of stress suggest lenders and investors should be mindful of potentially above-average credit risk in the coming years.
Equity Market Recap – S&P 500 Ends the Third Quarter with a Slight Loss
Stocks traded down slightly in the third quarter, with most of the losses occurring in August and September as rising interest rates weighed on equity market valuations. The S&P 500 ended the third quarter with a -3.2% return, while the Russell 2000 Index of small cap companies returned -5.2%. The Nasdaq 100, which tracks growth stocks, returned -2.9%. Despite negative returns during the quarter, the major stock indices have still posted strong gains this year. The S&P 500 has returned 13% through the end of September, while the Nasdaq 100 has gained 35.1% this year after trading lower in 2022.
Moving down to the sector level, Energy was the top-performing sector as oil prices climbed nearly 30%. Communication Services was the only other sector to trade higher, while the remaining nine sectors posted single-digit losses. Defensive sectors underperformed as rising interest rates weighed on the Utility, Real Estate, and Consumer Staple sectors.
International stocks underperformed U.S. stocks during the third quarter as rising Treasury yields caused the U.S. dollar to strengthen. The MSCI EAFE Index of developed market stocks returned -4.9%, while the MSCI Emerging Market Index returned -4.1%. Year-to-date, international markets have underperformed U.S. stocks due to their lower exposure to both growth-oriented stocks and the emerging artificial intelligence industry.
Credit Market Recap – Bonds Trade Lower as Interest Rates Rise
Rising interest rates were a significant headwind for bonds during the third quarter. Figure 4, which graphs the quarterly total return of the Bloomberg Bond Aggregate Index, puts the losses in perspective. The chart shows the Bond Aggregate Index, which tracks a wide array of Treasury, corporate, and municipal bonds, generated a total return of -3.2% during the third quarter. The negative total return indicates the decline in bond prices more than offset the interest received during the quarter.
The yellow line in Figure 4 shows bonds haven’t experienced a sequence of negative returns like the current trend since the 1970s, which was the last time the Fed aggressively raised interest rates to combat inflation. Factoring in the third quarter sell-off, four of the 10 worst quarters for the Bond Aggregate Index have occurred since the start of 2022. While savers are earning significantly more interest compared to the last decade, the higher interest income is being offset by falling bond prices.
Elsewhere across the bond market, riskier bonds continued to outperform higher-quality bonds during the third quarter. High-yield corporate bonds produced a total return of -0.3%, while investment-grade corporate bonds generated a -4.6% total return. The performance gap can be attributed to two factors. First, high-yield bonds typically have shorter maturities than investment-grade bonds. As a result, rising interest rates had less of an impact on high-yield bonds during the third quarter. Second, high-yield bonds offer a higher yield than investment-grade bonds to compensate for their increased credit risk. This higher yield boosted high-yield’s total return and offset a portion of capital losses.
Fourth Quarter Outlook – What to Watch?
After a challenging 2022, it’s been a good year for investors. Entering the fourth quarter, the S&P 500’s year-to-date return has already surpassed the average return for a full calendar year.
Several factors will influence how the market finishes this year, including the paths of oil prices and interest rates. Corporate earnings and economic data will also be at the top of many investors’ watchlists. The third-quarter earnings season starts in mid-October, and it will provide key insights into consumer spending and the impact of higher interest rates. On the economic front, investors will be focused on the labor market, the trajectory of inflation, and third-quarter GDP growth, which will be released in late October.
Our team will be tracking corporate earnings and economic trends throughout the fourth quarter to help guide portfolio positioning. The market is entering the final stretch of 2023, but there are still a lot of important data points to be released and questions to be answered before we turn the calendar to 2024.
Client Letter | 1Q 2023 Recap & 2Q 2023 Outlook
Financial Markets Start 2023 Strong But End the First Quarter on a Question Mark
First quarter economic data showed the U.S. economy entered 2023 with considerable momentum, even in light of the Federal Reserve’s interest rate hikes throughout 2022. Fourth quarter 2022 GDP data showed the U.S. economy grew at a +2.6% rate. The growth was largely driven by a resilient consumer, inventory restocking, and increased government spending, while businesses cut back their spending and the housing market remained weak. Additional economic data in Figure 1 highlights the broad economic trends. Jobs remain plentiful with job openings significantly above pre-pandemic trend, inflation is easing, and consumer spending remains above trend. The data shows growth is normalizing as the economy returns to its pre-pandemic trend but suggests the economy is withstanding higher interest rates thus far.
Financial markets turned rocky during the last month of the quarter. Three regional banks failed, and the U.S. Treasury bond market became more volatile as investors debated whether the Federal Reserve would continue to raise interest rates against an uncertain backdrop. This quarter’s recap discusses recent bank failures, including concerns about financial stability, and provides an update on year-to-date stock and bond returns.
Regional Banks Fail After Sudden Withdrawal Spree
Three regional banks failed in March as the banking industry faced a crisis of confidence and customers quickly withdrew deposits. The top chart in Figure 2 (next page) shows deposits at U.S. commercial banks rose from $13.2 trillion at the end of 2019 to a peak of $18.1 trillion in April 2022 as businesses and individuals flooded banks with new deposits during the pandemic. More recently, deposits at commercial banks decreased in 9 of the last 12 months. The bottom chart in Figure 2, which graphs the change in bank deposits from peak levels, shows total U.S. commercial bank deposits have declined -$607 billion since April 2022. The decline marks the biggest banking sector deposit outflow on record and is starting to stress bank balance sheets.
To meet withdrawal requests, banks maintain a portion of their assets as liquid reserves, such as government bonds and commercial paper, that can quickly be converted to cash. If banks exhaust the liquid reserves, they can either borrow from other banks and the Federal Reserve or sell assets, such as their bond holdings. This basic process helps explain why three banks failed.
Depositors overwhelmed the banks in early March with withdrawal requests. The banks exhausted their liquid reserves, could not obtain loans from other banks or the Federal Reserve in a time-efficient manner, and were forced to sell their most liquid assets, which consisted of U.S. Treasury bonds and mortgage-backed securities. The problem for the banks is interest rates are significantly higher than when the banks bought the bonds, and the bonds are now worth less. When the banks sold the bonds, the were forced to realize billions of dollars of losses, which drained their capital cushions and made them technically insolvent. State banking regulators and the FDIC immediately stepped in to take over the failed banks and protect depositors.
These recent bank failures have raised concerns about financial stability and drawn comparisons to 2008. However, there are important differences from 2008, including both regulatory changes and the causes of insolvency. Banking reforms after the 2008 crisis strengthened the overall financial system, and higher capital requirements now provide banks with a more robust financial cushion. In addition, regulators now possess greater authority to resolve issues in large, failed banks in order to avoid chaotic situations like the Lehman Brothers bankruptcy. In terms of cause, the 2008 crisis was primarily triggered by bad loans and complex securities. In contrast, recent bank failures resulted from the Federal Reserve’s rapid interest rate increases, which created paper losses for banks that made loans or purchased bonds at lower interest rates.
Navigating the Volatile Interest Rate Landscape
The Treasury market is experiencing more volatility and illiquidity because of conflicting signals about the strength of the U.S. economy and the Federal Reserve’s policy plans. Solid economic data in January showed the U.S. economy coping well with rising interest rates, suggesting the Federal Reserve may need to do more than anticipated to ease inflation. During early March congressional testimony, Federal Reserve Chair Jerome Powell spooked markets by suggesting the central bank would need to raise interest rates higher than initially thought and then keep interest rates higher for longer. The warning caused Treasury yields to rise and bonds to trade lower. Less than one week after Powell testified, multiple regional banks collapsed, causing worries about the U.S. financial system’s stability. Treasury yields reversed course and declined, causing bonds to trade higher. The two conflicting themes have resulted in wild price swings in the usually quiet Treasury market as traders place bets on the likelihood of future rate cuts.
Figure 3, which graphs the rolling 2-day percentage change in the 2-year U.S. Treasury yield, shows the recent spike in volatility. Taller bars indicate the 2-year Treasury yield experienced a bigger 2-day move. The chart looks like a heartbeat over the past 12 months, going up and down with occasional volatility as markets responded to new information. However, the far right of the chart shows a spike in both directions recently. The 2-year yield plunged -0.87% on March 13th after two regional banks failed over the weekend, its biggest 2-day decline since the Black Monday stock market crash in October 1987. After banking regulators took over control of the banks and the Federal Reserve introduced lending programs to stabilize the banking sector, the 2-year yield surged +0.35% on March 21st.
What is causing the volatility? Investors now fear the Federal Reserve faces a tough set of choices. The central bank must balance bringing inflation under control with minimizing damage to the U.S. economy. One factor complicating the central bank’s task and contributing to interest rate volatility is the lagged effect of monetary policy – it is difficult to model how 2022’s interest rate hikes already have and will impact the economy. As a result, there is little consensus inside the Federal Reserve on the path of monetary policy. The central bank’s Summary of Economic Projections, which provides forecasts for key economic indicators and offers insights into the future direction of monetary policy, shows a wide range of interest rate projections. Projections for interest rates at the end of 2024 range from 3.4% to 5.6%, while the 2025 projection range is 2.4% to 5.6%. With even the Federal Reserve uncertain about policy, interest rates could remain volatile in the coming quarters.
How does the volatility impact businesses, consumers, and investors? Treasury securities are considered safe-haven assets, used as collateral for loans and other debts, and serve as a benchmark for pricing other financial securities, such as corporate and municipal bonds, mortgages and other asset-backed securities, and money market instruments. Increased volatility and illiquidity can disrupt the flow of credit, making it more challenging to price loans and various other financial products. While current volatility is linked to uncertainty about Federal Reserve policy rather than financial system stress, the risk is interest rate volatility spreads to other corners of financial markets. For businesses and consumers, this could mean higher financing costs and more difficulty obtaining loans. For investors, this could mean borrowers are unable to refinance their maturing bonds and end up defaulting on their principal and interest payments.
Equity Market Recap – A Reversal in Performance Trends During the First Quarter of 2023
Stocks traded higher in January before giving up some of their gains in February and March. The S&P 500 Index of large cap stocks ended the first quarter up +7.4%, outperforming the Russell 2000 Index’s +2.7% return. Most of the S&P 500’s relative outperformance occurred in March as investors de-risked their portfolios following the bank failures. There was also a sizable shift in factor performance during the first quarter. The Russell 1000 Growth Index gained +14.3%, outperforming Russell 1000 Value’s +0.9% return. Like the S&P 500, the Growth factor’s relative outperformance occurred in March after the bank failures. Growth stocks tend to be higher quality businesses with stronger fundamentals, and recent bank failures may have motivated investors to rotate into higher quality companies. Regardless of the cause, Growth’s outperformance is a significant change from 2022 when the Federal Reserve’s interest rate increases weighed on expensive stock valuations.
The Growth vs Value performance reversal also shows up in first quarter sector returns, with Growth-style sectors outperforming. Figure 4 is a scatterplot that compares each sector’s 2022 return (vertical y-axis) against its first quarter 2023 return (horizontal x-axis). In general, the worst performing sectors in 2022 are the top performing sectors in 2023, while 2022’s top performing sectors are broadly underperforming to start 2023. Beyond the year-to-date performance reversal, there was no obvious preference for defensive or cyclical sectors.
Turning to global markets, international stocks posted positive returns during the first quarter. The MSCI EAFE Index of developed market stocks gained +9.0%, outperforming the MSCI Emerging Market Index’s +4.1% return. Europe was the top performing international region and boosted developed markets’ performance. The region managed to avoid a major energy crisis during the winter months thanks to unseasonably warm weather and efforts to secure alternative natural gas sources after Russia cut off most of its supply. Short-term gas prices have fallen from record highs, preventing severe shortages and rationing, although utility bills remain high. In Asia, all eyes remain on China as the country reopens after relaxing its Covid-zero restrictions. The reopening is expected to boost China’s economy, and potentially the global economy, but it is unclear how strong or lasting the growth will be.
Bond Market Recap – Riskier Bonds Underperform Due to Concerns About Refinancing Risk
Bonds traded in both directions during the first quarter, initially trading higher in anticipation of the end of the tightening cycle before trading back lower as the Federal Reserve hinted at higher interest rates for longer. Corporate investment grade bonds ended the first quarter with a +4.6% total return, outperforming corporate high yield’s +3.7% total return. Like equities, investment grade’s outperformance primarily occurred in March after bank failures raised concerns of increased default risk.
Tighter bank lending standards are becoming a concern in credit markets. For perspective, banks aggressively tightened lending standards during the last 12 months in anticipation of the Federal Reserve’s interest rate hikes slowing economic growth. With recent bank failures causing banks to question the stability of checking deposits, there is a risk that banks will adopt a more cautious approach to lending and reduce the total amount of credit they offer. The decreased credit supply and access to credit could have a domino effect, impacting the economy and financial markets over time. Borrowers, specifically high-yield issuers, could default on their debt if it becomes difficult and too expensive to refinance their maturing loans. Credit markets will be watching for signs of refinancing stress in the coming months.
Second Quarter Outlook – Back to the Fundamentals
The outlook is indecisive as financial markets close out the first quarter of 2023. Some investors believe the Federal Reserve’s actions will slow economic growth and tip the U.S. economy into a recession. This group points to recent bank failures as a warning sign that higher interest rates will have a negative impact. In contrast, some investors believe the U.S. economy is strong enough to withstand the Fed’s actions. This group points to first quarter economic data as a sign of strength and banking regulators’ actions as an indication the U.S. financial system is functioning as intended.
The back and forth is likely to continue until some of the market’s most pressing questions are answered. Key questions include the direction of Federal Reserve policy, the stability of the U.S. banking sector, inflation’s stickiness, corporate earnings growth, and the strength of the U.S. economy. Our team will be monitoring the answers to these questions in coming months to help guide investment portfolio positioning, with first quarter earnings season scheduled to start in mid-April.
As we have mentioned previously, the current investing environment requires a long-term outlook. Trend changes are frequent, fast, and driven by fluctuating market headlines, and keeping up with the day-to-day whims of the market can be emotionally taxing. Developing a financial plan and sticking to it are important steps to achieving your financial goals. Do not hesitate to reach out to our team if you have any questions or concerns about your financial plan or situation.
Client Letter | 2Q 2023 Recap & 3Q 2023 Outlook
Financial Markets Rebound in the First Half of 2023
A year can make a big difference. One year ago, the market was trying to catch its breath after a chaotic start to 2022. The Federal Reserve had raised interest rates by 1.5% in a little over three months. Inflation touched 9% as Russia’s invasion of Ukraine upended commodity markets and competition for employees resulted in wage inflation. The S&P 500’s first half 2022 return was its worst start to a calendar year since 1970. Fast forward 12 months, and the backdrop is markedly different. Oil prices are -33% lower, inflation is running at a 4.1% pace, and the S&P 500 is up +16.7% this year. This letter reviews the second quarter, recaps the strong start to 2023, and discusses the outlook for the second half of the year.
Data Highlights U.S. Economy’s Momentum
While the backdrop has significantly changed, second quarter economic data highlighted the U.S. economy’s continued resilience. In the housing market, new home sales rose more than 10% year-over-year in both April and May as tight inventories pushed homebuyers to the new construction market. Personal income, which measures an individual’s total income from wages, investments, and other sources, continued to grow along with wages and interest income. While unemployment rose slightly to 3.7%, companies added ~300,000 jobs in both April and May. Revised data showed the economy expanded at a faster pace in Q1 than previously estimated. First quarter U.S. GDP growth was revised up to a 2% annualized pace from the initial 1.3% estimate, reflecting upward revisions to exports and consumer spending.
The data underscores the economy’s momentum, but it’s backward-looking rather than forward-looking. How much longer can the U.S. sustain its economic strength? An index of leading economic datapoints suggests the U.S. may be near a turning point. Figure 1 compares the year-over-year change in the Leading Economic Index (LEI) against the Coincident Economic Index (CEI). For context, the LEI is an index of ten economic datapoints whose changes tend to precede changes in the overall economy, such as unemployment claims, building permits, and manufacturing hours worked. The CEI is an index of four datapoints that tend to move with the economy and provide an indication of the current state of the economy, such as industrial production and personal income. The gray shades represent past U.S. recessions.
The chart shows the LEI declined -8% during the past 12 months, an indication the economy may be approaching a turning point as the Fed’s interest rate hikes take effect. In contrast, the CEI rose +2% over the same period, an indication the economy currently remains strong. What does the LEI/CEI divergence imply? Positive CEI doesn’t necessarily mean the economy has avoided a recession, but CEI’s rise does provide additional evidence showing the U.S. economy’s resilience despite higher interest rates. On a related note, the chart shows it’s not uncommon for the LEI to decline even as the CEI remains positive. The red circles highlight prior instances like today, where LEI declined first and then CEI declined later. However, the gray shades show the U.S. economy has been near the start of a recession each time the LEI fell by more than -5% in 12 months.
S&P 500 Companies Beat Q1 Earnings Estimates
Corporate earnings tell a similar story to economic data. While the S&P 500’s earnings declined -2% year-over-year in the first quarter, an increasing number of companies reported results that exceeded analysts’ estimates. Figure 2 graphs the percentage of S&P 500 companies beating sales and earnings estimates during Q1 earnings season. The top chart shows 75% of companies beat their sales estimate in Q1, up from 65% the prior quarter and above the 5-year average of 69%. From an earnings perspective, 78% of companies beat their estimate, up from 69% the prior quarter and slightly above the 5-year average of 76%. Like the economy, investors appear to be underestimating corporate earnings strength.
A look ahead to Q2 earnings season reveals a dynamic that is similar to the LEI/CEI divergence. The S&P 500’s earnings are forecasted to decline -7.1% year-over-year in Q2 2023. For reference, analysts forecasted a -4.7% earnings decline back on March 31 before Q1 earnings season. It’s not uncommon for analysts to revise earnings estimates during earnings season as they get more up-to-date information from companies. The downward revision indicates analysts remain skeptical about companies’ ability to grow earnings in an environment with higher interest rates and the economy returning to trend after a period of strong growth over the past few years. Like economic data, the question is whether the downbeat earnings forecast or Q1’s better-than-expected actual results is more indicative of the path forward.
An Update on the U.S. Banking System
It’s been four months since the first signs of bank turmoil in early March, and data indicates the stress is easing. Bank deposits plunged in March after steadily declining for almost a year, but data from the Federal Reserve shows deposits stabilized in Q2. On a related note, there were concerns deposit outflows would cause banks to slow, and potentially shrink, their lending activity. However, another Federal Reserve dataset shows loans and leases on bank balance sheets held relatively steady in Q2. While banks are not increasing their lending activity, the data indicates they are not pulling back either.
The data suggests banks are on more stable footing today, but there are still questions about the banking system. Recent stability doesn’t necessarily rule out the risk of deposits continuing to trend lower, especially with interest rates remaining elevated. In addition, profitability is a concern. Why? Broadly speaking, banks make money by charging a higher interest rate on loans than the interest rate they pay on deposits. Now that depositors can earn a higher yield on bonds, banks must pay a higher interest rate on deposits. However, banks’ interest income is still tied to loans made during the past few years when interest rates were lower. An increase in interest expense without an offsetting increase in interest income means banks’ profit margins may decline. In addition, there is concern banks may lose money on consumer, business, and real estate loans if the economy weakens. The pressure on deposits eased in Q2, but banks may not be in the clear yet.
Equity Market Recap – The Rally Broadens Out
Equity markets are off to a strong start this year. After a steep sell-off in the first half of 2022, the S&P 500 returned +16.7% in the first half of 2023. The year-to-date gain ranks as the fifth strongest first half return since 1989. The biggest Technology stocks performed even better, with the Nasdaq 100 returning +15.3% in Q2 after its +20.7% Q1 return. The Nasdaq 100’s +39.1% return is the strongest first half year return since 1989, ranking ahead of both 1998 and 1999 during the dot-com bubble. Small cap stocks also participated in the rally, returning +8.1% through the end of June. The year-to-date equity market gains have lifted portfolios after a difficult 2022.
While the S&P 500’s headline return is impressive, a look underneath the surface tells a different story. Figure 3 compares the performance of the S&P 500 Index against an equal weight version of the S&P 500 Index. Why is this relevant? The S&P 500 Index is weighted by market cap, which means the biggest stocks can significantly impact the index’s headline return. An equal weight index neutralizes the impact of the biggest stocks and allows investors to track how the average stock is performing. The chart shows the two versions of the S&P 500 Index traded together in January and February, an indication market cap didn’t significantly impact performance.
However, the market cap and equal weight versions of the S&P 500 diverged in March when the first signs of regional bank turmoil appeared. The S&P 500 traded higher in April and May, while the Equal Weight S&P 500 traded sideways. The split indicates the biggest stocks drove a large portion of the S&P 500’s gain in Q2. While the S&P 500 ended the first half of 2023 with a strong return, the average stock’s return was noticeably smaller and indicates the first half rally was top-heavy. Investors will be watching to see if the first half S&P 500 rally broadens in the second half of the year.
After outperforming in the first quarter, international stocks underperformed U.S. stocks in the second quarter. The MSCI EAFE Index of developed market stocks gained +3.2%, outperforming the MSCI Emerging Market Index’s +1.0% return but underperforming the S&P 500 by -5.5%. Looking across international markets, Latin America was the top performing international region as both Brazil and Mexico traded higher. Latin America is benefitting from geopolitical tensions between the U.S. and China, which is pushing investment toward the region. Within developed markets, Asia outperformed Europe as Japanese stocks traded to a 30-year high. The catch – Japanese stocks are only now getting back to breakeven after the country’s late-1980s real estate bubble popped and the stock market crashed.
Credit Market Recap – Riskiest Bonds Outperform Due to Higher Yields
Treasury yields rose sharply in Q2 after ending Q1 lower due to regional bank stress. The 2-year Treasury yield, which is viewed as a proxy for Federal Reserve policy rate, rose from 4.06% to 4.87%. Over the same period, the 10-year Treasury yield rose from 3.49% to 3.81%. The increases are being attributed to better-than-expected economic data, which could in turn force the Fed to raise interest rates higher than previously thought. Rising interest rates weighed on bonds in Q2 with the Bloomberg U.S. Bond Aggregate, an index that tracks a wide array of Treasury, corporate, and other investment grade bonds, producing a -0.9% total return.
While rising interest rates caused bonds to trade lower, high yield corporate bonds traded higher in Q2 and produced a +0.7% total return. The top chart in Figure 4 takes the analysis a step further by comparing the return of CCC bonds, which are the lowest rated corporate bonds with a higher perceived risk of default, against a broad index of corporate investment grade bonds. The chart shows CCC-rated bonds generated a ~10% total return through June 30th, which includes both price appreciation and interest received. For comparison, investment grade bonds generated a ~3% total return over the same period. Why are the riskiest corporate bonds outperforming? They offer a higher yield as compensation for taking on more credit risk. An index of corporate investment grade bonds yielded 5.6% on June 30th, while an index of CCC bonds yielded 14.0%, almost 2.5x higher. The higher yield translates into more interest income, helping to boost total return.
The return gap is striking considering another credit market theme this year – rising bankruptcy filings. The bottom chart in Figure 4 graphs the monthly number of Chapter 11 bankruptcy filings since 2006. It shows the surge in bankruptcies during the 2008 financial crisis followed by the long tail of bankruptcies through 2013. The number of bankruptcy filings stabilized in 2014 and trended sideways through 2019. While there was a brief spike in 2020, the number of bankruptcy filings was below-average in 2021 and 2022. Why did bankruptcy filings decline during the pandemic? Companies benefitted from multiple themes, including low interest rates, fiscal stimulus, and loose bank lending standards. Those themes made financing plentiful and allowed even highly leveraged companies to refinance their old debt and take out new debt. Separately, rising inflation increased companies’ pricing power and drove strong sales growth, which in turn lead to higher profit margins.
The far right of the chart shows the tide is turning. The number of bankruptcy filings in March 2023 crossed above the 20-year median for the first time since December 2020, coming back in line with the pre-pandemic trend. What’s driving the increase? Several themes are contributing to the sharp rise in bankruptcies, including higher interest rates, tighter bank lending standards, and easing inflation. In summary, higher interest rates and tighter bank lending standards are increasing companies’ financing costs at the same time inflation is easing and companies are starting to lose pricing power. High yield bonds offer more income near-term, but that income is tied to credit risk. If the number of bankruptcy filings continues to increase, the losses from those defaults could more than offset the extra income investors earn near-term.
Third Quarter Outlook – Can the Good Times Continue?
The first half of 2023 was marked by continued economic resilience and a rebound in the equity market. The U.S. economy outperformed expectations despite the Fed’s aggressive 2022 rate hikes, with new home sales rising, personal income growing, and continued job creation. Corporate earnings exceeded expectations, and the S&P 500 gained more than 15%. In the credit market, the riskiest corporate bonds outperformed as investors collected higher yields.
As the market enters the second half of 2023, investors are left asking whether the good times can continue. The LEI indicates the U.S. economy may be nearing a turning point, and the economic data may start to show the cumulative effect of the Fed’s interest rate hikes. Plus, there is the potential for additional rate hikes in Q3. While the S&P 500 rally was impressive, it was also top-heavy, with larger stocks driving a significant portion of the gains. Corporate earnings are forecasted to decline, and bankruptcy filings could rise further if borrowers struggle to refinance and/or profit margins decline.
While the first half of 2023 was relatively calm, the economy and market face potential challenges in the second half of the year. Our team will continue monitoring conditions as they evolve and will be prepared to adapt portfolios if needed as the second half plays out.
