The first half of 2023 has concluded following a second quarter that saw concern on the direction of markets and the economy giving way to resilient data and optimistic sentiment. Throughout the quarter, investors received earnings reports, economic indicators, and banking sector news displaying that the worst-case scenario of an imminent, banking led recession in the US was not in the cards. Instead, the economy has maintained a steady course, showcasing resilience in consumer spending and employment. Even concerns surrounding the debt-ceiling negotiations came and went without much lasting effect. In addition to these factors, a wave of enthusiasm surrounding artificial intelligence and its transformative potential surged, driving significant gains in equity market indexes, particularly in technology stocks. The bond market, however, sees a less optimistic future as bond yields rose substantially on expectations of persistent global central bank hiking in response to stubborn inflation and an anticipated higher rate environment moving forward.
Q2 2023 Market Commentary
Investors in the US equity market have shaken off indications of a slowdown in the US economy due to Fed tightening and taken the path of least resistance higher given falling inflation, a strong labor market, and robust consumers.
Domestic equities posted another strong performance on the index levels as mega-cap, growth, and AI related names fueled a rally. Throughout this year, the index has been driven in large part by the most heavily weighted names by market capitalization as they contributed nearly 11% of the 14% YTD returns on the S&P 500. For the second quarter, the tech-heavy Nasdaq rose 12.8% compared to the S&P 500’s gain of 8.3% and the Dow Jones Industrial Average’s gain of only 3.4%. To further the point, 8 of 11 sectors underperformed the S&P 500 as Technology (+16.9%), Consumer Discretionary (+14.3%), and Communications (12.8%) were the only outperforming sectors. By contrast, Utilities (-3.3%), Energy (-1.8%) and Consumer Staples (-0.2%) were the biggest laggards.
At the latest Fed meeting a few weeks ago, the committee voted on their first pause in interest rate hikes after ten consecutive increases. Inflation has fallen rapidly to 4%, although that level remains well above the central bank’s target. The Fed has expressed a wait and see approach to lessen the risk of a larger slowdown given the lag effect in monetary policy. Given that economic data continues to surprise to the upside, supported by the services sector, it is very likely that rate hikes, not cuts are the base case for the rest of the year which makes the recent decision a “hawkish pause”.
Other economic developments: Manufacturing PMIs remain in contraction territory since the end of 2022. Q1 GDP growth was revised up to 2%, substantially more than the previous 1.3% estimate. The unemployment rate increased to 3.7% from 3.4%.
Foreign markets underperformed their US counterparts as the MSCI ACWI ex US advanced 1.4%.
The MSCI Eurozone Index rose less than domestic markets, advancing only 1.6%. Like the US, eurozone shares were boosted by technology stocks, although high inflation and lower growth projections caused underperformance. The European Central Bank hiked rates at their last meeting by 0.25% to 3.5%, the highest level in over two decades. The inflation projection for this year was raised to 5.1% from 4.6%. Currently, the bloc’s inflation rate stands at 6.1%. Unlike the US, the ECB faces a more uphill battle on the inflation front. The flash eurozone composite PMI’s fell to 50.3 in June from 52.8 in May. That represents a 5-month low.
Across the pond, the UK defied market expectations with a surprise 50 basis point rate hike at the end of the quarter. Bank of England Governor Andrew Bailey justified the decision, stressing the bank’s goal to return inflation back to 2%. Currently, the inflation rate is 8.7%, well above its international peers. The MSCI UK All Cap was down 0.6% given the higher mix of energy and materials making up the index.
Japanese markets have been a large surprise throughout the year and the Nikkei 225 was up 18.4%. The region hit the highest level in over 30 years as the Nikkei hit 33,700 in June. Yen weakness, stronger than expected earnings, and corporate governance reforms have been catalysts for the rise. At its most recent meeting, the Bank of Japan held its short-term interest rate target at -0.1% and made no changes to its yield curve control. The dovish stance comes as Japan’s core inflation rate stands at 3.4%.
Emerging markets had a volatile quarter, finishing flat. Recent data out of the largest member, China, showed a slower pace of growth as the recovery appears to be sputtering out. This comes after a faster than expected pace of growth in the first quarter. The detraction of China was counteracted by Hungary, Poland, and Greece. Brazil and India notched solid gains on optimistic growth projections and stronger earnings.
Despite relatively low volatility in the fixed income market, bond yields steadily rose throughout the quarter resulting in underperformance for the asset class. Central bankers worldwide continued to reiterate that their battle with inflation is not yet won, and more action is needed to force rising prices into submission. Ultimately, the Bloomberg Global Aggregate Index fell 1.5%.
In the United States, the Federal Reserve has been compelled to maintain its hawkish posture due to the sustained strength displayed in economic and inflation indicators, despite a pause in June. The central
bank’s stance, combined with the influx of volatility from the debt-ceiling negotiations, increased the market’s expectations for the path of interest rates going forward and elevated rates across the yield curve. The shorter end of the curve experienced a relatively greater rise as investors factored in the prospect of higher rates from the Fed. Meanwhile, concerns about long-term economic conditions kept the longer end of the curve subdued, exacerbating the inversion of the yield curve. The 2 year-10 year spread now rests at -100bps. Given this dynamic, long-term treasury bonds (-2.3%) underperformed their short-term counterparts (-0.6%) primarily due to their higher duration exposure. The US Agg Bond index returned -0.84% for the quarter.
Corporate credits, as a whole, delivered stronger performance compared to the treasury market, primarily driven by their reduced sensitivity to interest rate fluctuations. However, this outperformance was not uniform. High quality corporate bonds, which tend to have relatively more interest rate risk than their lower quality counterparts due to their safer credit risk profile, experienced losses for the quarter of 0.5%. Vice versa, stronger-than-expected company balance sheets and resilient economic data, which typically support high yield bonds disproportionately more, provided enough support for low-quality corporates to post gains of 1.75%.
Developed bond markets around the globe experienced a similarly challenging environment to the US. The UK fixed income market struggled mightily as inflation remains surprisingly high, forcing the Bank of England into aggressive hawkish action. The ECB has found itself between a rock and a hard place as economic sentiment in the Euro area continues to deteriorate while the central bank is forced to hike rates into the slowing to tame inflation. The Bank of Japan remain the only major central bank to refrain from tightening monetary policy in the face of price increases. As a result, demand for their bonds has diminished as investors seek higher yields elsewhere, leaving Japanese fixed income in the dust.
Traditional commodity markets extended their tough start to the year. Oil recorded another losing quarter, down near 6%, as global demand continued to deteriorate driven by the macro uncertainty, a weaker than expected China reopening, and the war in Ukraine. The S&P GSCI Precious Metals and Industrials Metals indices also posted a negative quarter as they fell 3.0% and 9.8% respectively.
The increase in treasury rates combined with a pullback in lending from regional banks provided another catalyst for one of the fastest-growing sectors of the private markets. From Q4 2021 to Q1 2023, asset level yields have increased from 7.1% to 12.6%. Increasingly private equity firms are turning to direct lenders for financing instead of traditional high yielding bonds. The increased demand for private credit has provided lenders with leverage to secure more attractive terms for their financing.
Mega cap buyouts and IPOs have slowed as managers navigate the ongoing macro-economic issues. Despite the slowdown in deal making and increased borrowing costs, private equity funds are still sitting on elevated levels of dry powder. Managers have become more selective about purchasing the right assets at fair prices with a clear path toward value creation. Increased diligence and longer deal timelines will slow the deployment cycle for funds and provide greater time diversity to the limited partners.
Crypto had another strong quarter, making it the best performing asset year-to-date, with Bitcoin up 83% and Ethereum up 55%. Over the past several weeks, many large asset management companies have filed to develop Bitcoin spot ETFs which could allow a larger group of investors to gain exposure and increase future demand for these investments.