U.S. Economy: Growth, Lower Inflation
Inflation remains the major focus as investors evaluate how much more the Fed might raise its key interest rate, recently at 5.25%- 5.50%, the highest level in 22 years. The PCE price index, one of the Fed’s preferred measures, fell to 3.0%, the slowest pace in the last two years. Meanwhile, U.S. GDP growth accelerated to 2.4% in Q2 from 2.0% annualized in Q1.
U.S. Stocks: Resilience Drives Gains
U.S. equity performance was marked by investor sentiment that a recession, should one occur, could be less severe than initially feared. The Dow Jones Industrial Average marked 14 consecutive days of gains, the longest daily up streak since 1987. More economically sensitive small-cap stocks outperformed large-cap for the second consecutive month.
Foreign Stocks: Emerging Markets Lead
International equities were lifted by better economic data while many developed market economies continued to battle inflation. With more U.S. rate hikes in doubt, weakness in the U.S. dollar was a tailwind for certain emerging markets. Turkey (+19.3%) soared on a UAE economic support deal and South Africa (+12.6%) on potential interest rate cuts.
Fixed Income: Uneven Results
Financial markets are pricing in that the Fed is near the end of its interest rate hikes after increasing its target rate 0.25% in July. Investment grade taxable bonds were modestly negative but municipal bonds outperformed on limited supply, as did emerging market debt, with many countries looking to implement less restrictive monetary policy.
Real Assets: Commodity Comeback
Certain real assets were positive during the month, with commodities (+6.3%) one of the prime beneficiaries of improved economic sentiment. Oil (+11.9%) rallied on the global heatwave and limited production, while industrial metals (+6.9%) benefited from forecast demand. Meanwhile, more defensive infrastructure stocks returned a modest 1.3%.
Alternatives: Diversification and Returns
Hedge funds typically underperform stocks during rallies like we have seen year-to-date. But they continue to outperform fixed income while reducing risk by being uniquely positioned to capitalize on market dislocations should they materialize. Market directional hedge funds (+5.2%) have been the strongest performers in 2023 given strong global equity results.
Source of data: Bloomberg
Equities Total Returns
Fixed Income Returns
Macroeconomic forces are playing a game of tug-of-war despite robust stock market results that seem to belie that notion. It is undeniable that the financial markets have been fueled by consensus sentiment that the U.S. economy appears likely to avoid a severe recession and the worst-case scenarios for inflation have subsided. Some optimism is indeed warranted. A number of high-level macroeconomic indicators are painting a better picture than they did in January, including resilient GDP growth and cooling inflation. U.S. consumer spending has also held up better than expected to this point, with jobs plentiful and wage gains recently starting to outpace inflation.
We had previously noted that S&P 500 returns were being driven by a handful of stocks. The “enormous eight,” including Apple (+52%) and Nvidia (+220%), account for 77% of the gains of the S&P 500 Index return through July. Such concentration possibly overstates actual investor optimism as those stocks are benefiting from idiosyncratic tailwinds such as lower inflation and artificial intelligence. However, July showed broader results, with the other stocks in the index and small caps participating in the gains. Could that mean the recent equity market has legs? Possibly.
Consider a key force pulling the other way: 11 interest rate increases by the Fed since March 2022 after an era of low rates on mortgages and personal credit. The slowing effect on consumer demand has arguably not yet materialized, but the impact may become evident later this year as U.S. credit conditions have tightened significantly. Banks are increasing lending standards and the interest rates on their loans, both of which will undoubtedly be felt by consumers and businesses in the coming quarters as their need for new loans or refinancing compels them to borrow at higher rates.
The process of borrowers being forced into higher-rate debt over an extended period is often referred to as the “long and variable lags of monetary policy.” According to Experian, the average payment for a new car auto loan was recently $725 vs. $554 in the fall of 2019. The recent downgrading of the U.S. credit rating to AA+ by Fitch Ratings may have an impact on the credit markets, but as of now that impact does not appear material.
Artificial intelligence could be a tailwind that boosts U.S. productivity and profit margins, although the long-term opportunity set remains unclear. Right now, most of the winners in the AI race are mega tech stocks uniquely positioned for the growing use of AI and already prominently featured in most equity portfolios. Still, as was the case with the dotcom boom, the winners at the end of the race aren’t necessarily the ones at the beginning.
What We Are Doing
As we said in our latest Commentary, attempting to call market peaks and troughs is a fool’s game. Instead, we will stick to what we do best, being disciplined and unemotional and focusing on the areas over which we can exert some degree of control, such as portfolio asset allocation. One reconsideration for investors now involves equities. While equity valuations are stretched, fixed-income yields are well above the 10-15 year average. For example, high-quality, intermediate-term fixed income now yields 4% to 6% (vs. 1%-2% a year ago.)
Given the 2023 gains in stocks, rebalancing to strategic long-term allocations might make sense for portfolios overweight relative to strategic targets (or close to the high end of the range) in order to reduce risk and lock in a portion of the outsized year-to-date equity gains. Second, some portfolios may not need to take as much risk to generate the total return needed to meet client goals and objectives; consideration should be given to increasing the strategic targets to fixed income. Lastly, this could be an opportune time for some to trim public equity risk in favor of private equity, private credit, and hedge funds, currently among our strongest conviction for long-term goal attainment.
Glossary of Indices
U.S. Large Capitalization = S&P 500 Index
Tracks the performance of a representative sample of 500 leading companies in the major industries of the U.S. economy.
U.S. Small Capitalization = Russell 2000 Index
Tracks performance of the 2,000 smallest companies in the Russell 3000 Index, representative of the U.S. small capitalization equity market.
U.S. Growth Equities = Russell 3000 Growth Index
Tracks the performance of those Russell 3000 companies that have higher price-to-book ratios and higher forecasted growth values.
U.S. Value Equities = Russell 3000 Value Index
Tracks performance of those Russell 3000 companies that have lower price-to-book ratios and lower forecasted growth values.
International Equities (Developed Countries) = MSCI EAFE Index
A float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. Consists of the stock market indices of these 20 developed countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
Emerging Market Equities = MSCI Emerging Markets Index
A float-adjusted market capitalization index designed to measure equity performance in the major emerging markets. Consists of the following 25 emerging-market -country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
U.S. FIXED INCOME, TAXABLE
U.S. Aggregate Bond = Barclays Capital U.S. Aggregate Bond Index
Covers U.S. dollar-denominated, investment-grade, fixed-rate, taxable bond market consisting of SEC-registered securities. Includes U.S. Treasuries, U.S. agency bonds, U.S. corporates, mortgage-based securities (MBS, CMBS) and asset-backed securities (ABS).
TIPS (Treasury Inflation-Protected Securities) = Barclays U.S. Treasury Tips Index
Measures the performance of TIPS of various maturities issued by U.S. Treasury.
INTERNATIONAL FIXED INCOME
International Developed Bonds = BofA Merrill Lynch Global Government Bond II ex U.S.
Measures the performance of non-U.S. developed-market government bonds on an unhedged currency basis.
Emerging Market Bonds = BofA Merrill Lynch Emerging Markets Sovereign
Bond Index Measures the performance of emerging markets government bonds on an unhedged currency basis.
U.S. FIXED INCOME, TAX-EXEMPT
Intermediate Municipal Bonds = Merrill Lynch Municipals, 3-7 Yrs Index
A subset of The Merrill Lynch U.S. Municipal Securities Index, including all securities with a remaining term to final maturity of between 3 and 7 years.
Municipals, Broad Market = Merrill Lynch Municipal Master Index
Tracks the performance of U.S. dollar denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions.
Absolute Return Funds = HFRX Absolute Return Index
Tracks the performance of hedge funds aiming to provide stable performance regardless of market conditions. Such funds tend to be less volatile and less correlated to market benchmarks. Data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month and is subject to revision.
Market Directional Funds = HFRX Market Directional Index
Tracks the performance of hedge funds that add value by participating in the direction of various financial markets. Such funds characteristically have higher expected volatility than Absolute Return strategies (see above). Performance data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month, and is subject to revision.
Equity Volatility = CBOE VIX Index
Aims to measure investor expectations for near-term stock-market volatility as conveyed by the pricing of stock options on the S&P 500 index that mature within 30 days.
Implied Inflation = 10-Yr TIPS Implied Inflation
Gauges investor expectations for future U.S. inflation based on the difference between the yield on a 10-year TIPS (Treasury Inflation Protected Security) and the yield on a nominal 10-year Treasury.
Gold Spot $/oz.
An index intended to measure the current price of gold, based on futures contracts deliverable in the following month priced in U.S. dollars per Troy ounce.
Oil = Brent Crude Oil Spot Price $/bbl
Brent Crude Oil refers to a particular grade of crude oil often quoted in financial reports as the global benchmark for the price of oil. It typically trades at a premium to the West Texas Intermediate price.
U.S. Dollar = Trade-Weighted U.S. Dollar Index
Value of the U.S. dollar relative to a composite of 26 currencies of major U.S. trade partners, weighted based on trade data.