The first half of 2023 was certainly a positive one for the economy and financial markets. The US economy added over 1.6 million jobs, supporting the broad consumption of goods and services. Inflation readings slowed as the effects of Federal Reserve policy worked their way through the economy and businesses enjoyed a healthier operating environment, including lower input costs, improved labor availability and better functioning supply chains. With these considerable tailwinds, the US equity market as measured by the S&P 500 Index entered a new bull market in June.
Yet this strong start to the year has taken many by surprise, particularly those overly distracted by the threat of a recession. A year ago, the Federal Reserve was playing catch-up to high inflation and needed to slow down the economy. Market pundits were hailing the impending economic slowdown as the most anticipated recession in history. In our July 2022 Outlook, we voiced our concerns that investors were overly focused on whether the US economy was headed into a recession. Now twelve months and seven interest rate hikes later, while risks to economic growth remain, we still do not see a significant slowdown on the horizon. Good long-term investing is not about making great decisions, but about consistently not making big mistakes. Instead of taking pre-emptive action around the consensus recession, we focused on the building blocks of successful long-term investing – committing to the right asset allocation based on risk tolerance and time horizon, rebalancing portfolios to target allocations, tax loss harvesting, managing duration of fixed income portfolios, and optimizing returns on cash balances. We believe these actions have and will continue to serve our client portfolios well.
The US economy grew +1.8% in the first quarter of 2023, and we believe it is on track to grow 2-2.5% in the second quarter. Employment gains and wage growth continue to support consumer spending, which accounts for roughly two-thirds of GDP. The US economy has added jobs for 30 consecutive months, underpinning the historically low 3.6% unemployment rate. Labor participation rates, an estimate of the economy’s active workforce, have been steadily improving, particularly within the vital 25-54 year old cohort. However, the resilience of the economy and labor market can be seen as a double-edged sword for investors. Traditionally seen as a positive tailwind for financial markets, today’s economic strength makes it hard for the Federal Reserve to rein in its fight against inflation. The pace of inflation has declined to +3.8% in May, as measured by the Personal Consumption Expenditure (PCE). We expect inflation to continue to trend down towards 3% by year-end, a trend that would support the Federal Reserve holding interest rates steady at current levels. But recent remarks from the Federal Reserve suggest further tightening is coming. Time will tell if the Federal Reserve can “take a win” before further tightening significantly impairs the economy. Either way, we believe this tightening cycle is close to being done, and an accommodative Federal Reserve can be a powerful tailwind for US equity markets and other risk assets.
Against this improving backdrop, global equity markets continued their rebound in the second quarter. US Large Cap Equities, as measured by the S&P 500 Index, returned +9% and are +17% for the year. The index has now recovered 25% from its October 12th low. The rally has pushed valuations higher, with 12-month forward price-to-earnings ratios near 19x. While by no means cheap, we believe overall market valuations remain reasonable based on current corporate earnings expectations. S&P 500 forward earnings estimates have already been revised ~10% lower amidst concerns of an economic slowdown yet are still expected to deliver $245 of earnings per share in 2024 and $274 in 2025 (representing 12% annual growth above 2023’s consensus expectation of $218). If these estimates are achieved, and we believe they can be, the market is trading in line with historical averages. We are also cognizant that the stock market overall has done worse than the indices make it appear. The S&P 500 index is up 17% for the year, but the average US Large Cap stock is only +6%. Much of this can be explained by the dominance of the largest handful of companies. Within the S&P 500 Index, the top ten companies now account for nearly 32% of the index. These 10 stocks collectively trade at 30x forward earnings, while the remaining 490 stocks trade below 18x. We believe this dynamic may not only create risks to traditional market cap indexing going forward, but also creates opportunities within the rest of the market. We remain Neutral weight to US Large Cap Equities. US Mid Cap Equities (S&P 400 Index) and US Small Cap Equities (S&P 600 Index) rallied in the second quarter but continued to trail their larger counterparts this year (+9% and +6% respectively year-to-date). Headwinds to Mid and Small Cap Equities have included recessionary fears, higher interest rates, and instability of the banking system. These concerns are all justifiable, as many smaller companies may not have all the same tools at their disposal to weather a recession. But at 14x forward earnings estimates, there may be more upside for companies that do. We remain Neutral weight to US Mid and Small Cap Equities in our asset allocation models.
Developed Markets Equities, as measured by the MSCI EAFE Index, returned +12% year-to-date and Emerging Market Equities, as measured by the MSCI EM Index, returned +5% year-to-date. Despite these positive returns, the uncertainty of global growth, inflation and geo-political tension continue to be headwinds for these asset classes. While we acknowledge the reality of these uncertainties, we believe that investors are being fairly compensated for these risks with current valuations. The MSCI EAFE index now trades at 13x forward earnings with a 3.1% dividend yield, and the MSCI EM index trades at 12x forward earnings. These valuations are significantly lower compared to those in the US and remain attractive versus long-term averages. We also think that the recent weakening of the US dollar, after years of strength versus other global currencies, is a trend that will continue and will provide a positive tailwind for the performance of Non–US Equities. We remain Neutral weight to Non–US Developed Market Equities and slightly Overweight to Non–US Emerging Market Equities.
Global Real Estate Investment Trusts (REITs) returned +2% year-to-date, as measured by the FTSE Developed Real Estate Index. On the surface, real estate has faced somewhat of a perfect storm: higher interest rates have lowered valuations and increased borrowing costs; economic uncertainty and a stalling “return to office movement” lowered demand expectations; and a pullback in lending by regional banks, who dominate the commercial real estate market, has reduced liquidity. But we still believe Real Estate, whether public or private, belongs in a well-diversified portfolio. Real Estate is a large and vast market that spans across many property types and sectors. Yes, office REITs are down 60% from pre-COVID highs, but make up less than 4% of the $1 trillion public real estate market. Sectors such as warehouse/logistics and data centers are thriving. Apartment owners are enjoying healthy rental demand with homebuyers sidelined by higher mortgage rates and lack of supply. We believe current valuations and dividend yields are attractive, particularly in public REITs which trade at historically wide discounts to Net Asset Value (NAV). We remain Neutral weight.
The Federal Reserve raised short-term interest rates by 25bps in May, bringing the target Fed Funds rate to 5-5.25%. In June, the Fed held rates steady for the first time since January 2022. We hope the Fed continues to pause, but think it’s likely the Fed will err on the side of tightening too much rather than too little after being caught so far behind inflation in 2022. We frequently talk about the importance of diversifying equity portfolios, but diversifying fixed income portfolios can be equally essential. Fixed income portfolios can be diversified across issuer, credit quality, and perhaps most importantly, duration. Investors wooed by the high interest rates currently offered on cash are not taking on any duration. Among other things, this presents investors with significant reinvestment risk – the chance that you can only re-invest money at a lower rate in the future. Short-term cash interest rates are “short-term” and are only attractive until they are no longer available. With the 10 year US Treasury around 4%, we believe long-term investors should extend duration to take advantage of higher interest rates to lock in stability and income to their portfolios. We were aggressive in shortening duration when interest rates were near zero but have been steadily increasing duration over the last year to benefit from this income in client portfolios for years to come.
