- Federal Reserve appears to be slowing a strong economy as opposed to wrecking a weak one.
- Equities continued to show positive performance in Q2 led by US growth stocks, while international returns slowed.
- We favor stocks over bonds due to improving fundamental and technical conditions.
Quarterly Recap: Markets Climb The “Wall of Worry” as Earnings Come Through, Allowing Investors to Look Beyond Fed’s Immediate Actions.
We ended the first quarter of 2023 on a bit of a cliffhanger – Silicon Valley Bank and First Republic had failed, and we were waiting for the next shoe to drop, especially since the Federal Reserve clearly signaled that lowering inflation was a higher priority to sustaining economic growth. The 3-4 rate cuts in '23 that investors had anticipated at the start of the quarter quickly dissipated as inflation remained above the Fed's 2% target. The Fed's resolve to stay tight until inflation was brought down to their target contributed to the rise in long-term interest rates in the quarter. And while inflation cooled year over year, it continues to point well above the Fed’s target of 2%.
The previous paragraph may read like a setup explanation of some bad market returns, but a few key factors led to a positive return quarter for equity investors. First, and most important in our view, was the Q1 earnings season. Where the market anticipated poor Q1 earnings due to the full year effect of higher interest rates as well as the accompanying economic uncertainty, the S&P 500 was able to grow revenues by 12.1% and earnings by 6.0% Year-Over-Year. Current earnings and revenue growth also surprised analysts, with revenue 2.5% higher than expected and earnings 6.6% greater than expected. These two data points went a long way to demonstrate that large US companies were more resilient than many might have thought during the 2022 bear market. Similarly strong results were evident in other asset classes, including Developed International and US Small-Caps, while Emerging Markets were more mixed.
The second factor that gave the markets a boost was continued economic strength in key areas, such as housing, labor markets, and consumer spending. While the continuing consensus amongst economists is that the US will soon face a recession, the resilience of core data in the face of rising rates has given investors some degree of confidence that the Fed is slowing a strong economy as opposed to wrecking a weak one. The combination of higher inflation and positive but slowing economic growth provides an economic justification for the earnings surprises seen in the S&P 500 and elsewhere.
Finally, the momentum of RiverFront's three tactical rules turned more positive. First, the Fed became friendlier to markets as they indicated that they were approaching the end of their tightening cycle. Second, the trend for US large-caps, as measured by the 200-day moving average, flipped to positive sending the index above overhead resistance at 4200 closing the quarter at 4450. Third, investors remained relatively pessimistic throughout the quarter, which created the ‘wall of worry’ necessary for bull markets to climb. We believe that this rally can continue into future quarters, given that the tailwind of higher inflation should contribute to nominal earnings growth that exceeds analysts’ expectations.
Returns Recap: Equity Markets are Still Positive in Q2, but International Equity Markets are Decelerating.
As the market began to price in lower inflation, growth stocks, especially the US Technology sector, extended the rally that began at the end of the first quarter. This acceleration led to an equity leadership change from Developed International back to US Large-Cap. Developed International equities lagged but were still able to post a positive return. In fact, every major equity asset class saw a positive return in Q2 2023, though Emerging Market returns were minimal.
On the fixed income side, traditional fixed income saw negative returns. These assets classes, like investment grade fixed income and US treasuries, tend to have a high amount of interest rate sensitivity. As such,rising rates in the second quarter caused returns to be below zero. High yield, on the other hand, tends to have more credit sensitivity than interest rate sensitivity and benefits when default rates remain low, as they did in Q2.For this reason, high yield was able to post positive second quarter returns, though it still lagged most equities classes.
US Sectors: Growth Oriented Sectors Still in the Lead
Looking at US sectors, the second quarter of 2023 looked a lot like the first. The traditionally growth-oriented sectors of Technology, Communication Services, and Consumer Discretionary led the way, and were the only sectors to outperform the broad S&P 500 for the second straight quarter. At the bottom of the sector rankings, Energy and Utilities produced negative returns, but they, as well as Health Care and Financials, were able to produce higher returns than in the prior quarter.
International: Developed Markets Still Lead Emerging Markets
For the most part international returns looked a lot like Q1 of 2023 with two notable exceptions. First developed international markets dropped below US large-cap returns, an example of the growth-oriented leadership we discussed in the previous section. Second, Canada produced the second highest international return, trailing only Japan. A large amount of Canada’s return came from its currency versus the US dollar, as displayed in the third column of Table 3.
Looking at Developed Markets from a selection lens, we see that growth and quality themes under performed value themes and broad EAFE (Table 4). This dynamic could explain EAFE’s underperformance relative to the US. While growth themes are driving US returns, EAFE’s growth stocks are not producing equivalent returns.
For emerging markets, China reversed its leadership in the space. In fact, China was the only major international region to produce a negative return in the second quarter. This return is more in line with what we are seeing when looking at Chinese economic data and geopolitical relations, which continue to create a shadow over the reacceleration of their economy.
Outlook: Stronger Evidence of our Base and Even Best Scenarios Coming to Path
Overall, the first half of 2023 was positive for investors, especially given the mid-quarter banking crisis and the continued geopolitical conflicts in Europe and China. While the Federal reserve is certainly capable of overdoing rate increases, and inflation could re-emerge, we believe that companies and markets are successfully navigating higher rates and uncertainty.
As discussed in our 2023 Outlook, we see three likely outcomes of this standoff:
- Economic Growth: Slowing, but Positive / Inflation: Moderating, but Persistent (BASE CASE / MOST LIKELY OUTCOME)
In this scenario, the Fed will be proven correct and interest rates must go higher to combat inflation. If this plays out, we believe equity investors should expect volatility but directionless markets, an environment where we believe the P.A.T.T.Y theme (a focus on investments with strong yields and free cash flows to support them) would be the most effective strategy.
- Economic Growth: Resilient / Inflation: Under Control (BULL CASE)
Specifically, a recession or significant slowdown quickly emerges, causing inflation pressures to dissipate quickly. In this scenario, the bond market wins the standoff, and the Fed would begin to forecast rate cuts and/or monetary stimulus. In this scenario, quality and growth-oriented US equities would be the strongest performers, in our view. Additionally, international stocks would benefit from strong currencies.
- Economic Growth: Recessionary / Inflation: Strong (BEAR CASE)
The most challenging scenario is if we see high inflation and evidence of a recession, which would force the Fed to continue to raise rates even in the face of a recession. In that scenario, bonds and stocks would perform poorly as long interest rates rise and economic and earnings growth fall.
Our belief is that the Bull and Base Case are now more likely, which is why we currently favor stocks across our balanced portfolios.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.