Investments

Declining Inflation and Resilient Growth Push Stocks Higher in Q2

The S&P 500 ended the second quarter and first half of 2023 at a 14-month high and most major stock indices logged solid gains in the second quarter following a pause in the Fed’s rate hike campaign, stronger-than-expected corporate earnings (especially in the tech sector) and the relatively drama-free resolution of the debt ceiling.

The second quarter began with markets still in the throes of the regional bank crisis following the March failures of Silicon Valley Bank and Signature Bank, and investors started the month of April wary of contagion risks. Those concerns proved mostly overdone, however, as throughout most of the month regional banks were stable. That stability allowed investors to re-focus on corporate earnings, and the results were much better than feared as 78% of S&P 500 companies reported better-than-expected Q1 earnings, a number solidly above the 66% long-term average. Additionally, 75% of reporting companies beat revenue estimates for the first quarter, also well above the long-term average. That solid corporate performance was a welcome sight for investors and coupled with general macroeconomic calm, allowed stocks to drift steadily higher throughout most of April. However, following an underwhelming earnings report, concerns about the solvency of First Republic Bank weighed on markets late in the month and the S&P 500 declined into the end of April to finish with a modest gain.

Fears of a First Republic Bank failure were realized on May 1^st, as the bank was seized by regulators and the FDIC was appointed its receiver. However, that same day, JPMorgan announced it was acquiring the bank from the FDIC, and that move helped to calm investor anxiety about financial contagion risks. The Federal Reserve also helped to distract investors from the First Republic failure, as the Fed hiked rates at the May 2^nd FOMC meeting, but importantly altered language in the statement to imply it would pause rate hikes at the next meeting. That change was expected by investors, however, and as such it failed to ignite a meaningful rally in stocks. Instead, the tech sector helped push the S&P 500 higher in mid-May, thanks to an explosion of investor and financial media enthusiasm around Artificial Intelligence (AI), which was highlighted by a massive rally in Nvidia (NVDA) following a strong earnings report. However, like in April, the end of the month saw an increase in volatility. This time it was thanks to the lack of progress on a U.S. debt ceiling extension and rising fears of a debt ceiling breach and possible U.S. debt default. However, a two-year debt ceiling extension was agreed to by Speaker McCarthy and President Biden on May 28^th and was signed into law a few days later, avoiding a financial calamity. The S&P 500 finished May with a slight gain.

With the debt ceiling resolved, a Fed pause in rate hikes expected and continued stability in regional banks, the rally in stocks resumed in early June and was aided by several potentially positive developments. First, inflation declined as the Consumer Price Index (CPI) hit the lowest level in two years. Second, economic data remained impressively resilient, reducing fears of a near-term recession. Finally, in mid-June, the Federal Reserve confirmed market expectations by pausing rate hikes and that helped fuel a broad rally in stocks that saw the S&P 500 move through 4,400 and hit the highest levels since April 2022. The last two weeks of the month saw some consolidation of that rally thanks to mixed economic data, political turmoil in Russia and hawkish rhetoric from global central bankers, but the S&P 500 still finished June with strong gains.

In sum, markets were impressively resilient in the second quarter and throughout the first half of 2023, as better-than-feared earnings, expectations for less-aggressive central bank rate hikes, more evidence of a “soft” economic landing and relative stability in the regional banks pushed the S&P 500 to a 14-month high.    

Second Quarter Performance Review

The second quarter of 2023 saw an acceleration of the tech sector outperformance witnessed in the first quarter, as “AI” enthusiasm drove several mega-cap tech stocks sharply higher. Those strong gains resulted in large rallies in the tech-focused Nasdaq and, to a lesser extent, the S&P 500 as the tech sector is the largest weighted sector in that index. Also like in the first quarter, the less-tech-focused Russell 2000 and Dow Industrials logged more modest, but still solidly positive, quarterly returns. 

By market capitalization, large caps outperformed small caps, as they did in the first quarter of 2023. Regional bank concerns and higher interest rates still weighed on small caps as smaller companies are historically more dependent on financing to maintain operations and fuel growth.

From an investment style standpoint, growth handily outperformed value again in the second quarter, continuing the sharp reversal from 2022. Tech-heavy growth funds benefited from the aforementioned “AI” enthusiasm. Value funds, which have larger weightings towards financials and industrials, relatively underperformed growth funds, as the performance of non-tech sectors more reflected the broad economic reality of mostly stable, but unspectacular, economic growth.

On a sector level, eight of the 11 S&P 500 sectors finished the second quarter with positive returns. As was the case in the first quarter, the Consumer Discretionary, Technology, and Communication Services sectors were the best performers for the quarter. The surge in many mega-cap tech stocks such as Amazon (AMZN), Apple (AAPL), Alphabet (GOOGL), Meta Platforms (META), and Nvidia (NVDA) drove the gains in those three sectors, and they handily outperformed the remaining eight S&P 500 sectors. Industrials, Financials, and Materials saw moderate gains over the past three months, thanks to rising optimism regarding a “soft” economic landing.  

Turning to the laggards, traditional defensive sectors such as Consumer Staples and Utilities declined slightly over the past three months, as resilient economic data caused investors to rotate to sectors that would benefit from stronger than expected economic growth.  Energy also posted a slightly negative return for the second quarter, thanks to weakness in oil prices. 

US Equity Indexes	Q2 Return	YTD
S&P 500	10.32%	16.89%
DJ Industrial Average	5.28%	4.94%
NASDAQ 100	17.33%	39.35%
S&P MidCap 400	6.70%	8.84%
Russell 2000	7.24%	8.09%

Internationally, foreign markets lagged the S&P 500 thanks mostly to the relative lack of large-cap “AI” exposed stocks in major foreign indices, combined with some late-quarter worries about the EU economy and pace of Bank of England rate hikes, although foreign markets did finish the second quarter with a modestly positive return. Foreign developed markets outperformed emerging markets thanks to a lack of significant economic stimulus in China, which weighed on emerging markets late in the quarter.  

International Equity Indexes	Q2 Return	YTD
MSCI EAFE TR USD (Foreign Developed)	3.63%	12.13%
MSCI EM TR USD (Emerging Markets)	1.50%	5.10%
MSCI ACWI Ex USA TR USD (Foreign Dev & EM)	3.13%	9.86%

Commodities saw modest losses in the second quarter as most major commodities declined over the past three months. Oil prices witnessed a moderate drop despite a surprise production cut from Saudi Arabia and an increase in geopolitical tensions in Russia, as concerns about future economic growth and oversupply weighed on oil. Gold, meanwhile, posted a modestly negative return as inflation declined while the dollar failed to meaningfully drop.  

Commodity Indexes	Q2 Return	YTD
S&P GSCI (Broad-Based Commodities)	-1.45%	-7.54%
S&P GSCI Crude Oil	-5.21%	-12.40%
GLD Gold Price	-3.08%	5.23%

Switching to fixed-income markets, the leading benchmark for bonds (Bloomberg Barclays US Aggregate Bond Index) realized a slightly negative return for the second quarter of 2023, as the resilient economy and hope of a near-term end to Fed rate hikes led investors to embrace riskier assets.   

Looking deeper into the fixed-income markets, shorter-duration bonds outperformed those with longer durations in the second quarter, as bond investors priced in a near-term end to the Fed’s rate hike campaign, while optimism regarding economic growth caused investors to rotate out of the safety of longer-dated fixed income.

Turning to the corporate bond market, lower-quality, but higher-yielding “junk” bonds rose modestly in the second quarter while higher-rated, investment-grade debt logged only a slight gain. That performance gap reflected investor optimism on the economy, which led to taking more risk in exchange for a higher return.  

US Bond Indexes	Q2 Return	YTD
BBgBarc US Agg Bond	-0.38%	2.09%
BBgBarc US T-Bill 1-3 Mon	1.23%	2.33%
ICE US T-Bond 7-10 Year	-1.32%	1.62%
BBgBarc US MBS (Mortgage-backed)	-0.41%	1.87%
BBgBarc Municipal	0.04%	2.67%
BBgBarc US Corporate Invest Grade	0.40%	3.21%
BBgBarc US Corporate High Yield	2.60%	5.38%

Third Quarter Market Outlook

As we begin the third quarter of 2023, the outlook for stocks and bonds is arguably the most positive it’s been since late 2021, as inflation hit a two-year low, economic growth and the labor market remain impressively resilient, the Fed has temporarily paused its historic rate hiking campaign, the debt ceiling extension is resolved, and we’ve seen no significant contagion from the regional bank failures from earlier this year.

That improvement in the fundamental outlook has been reflected in both stock and bond prices so far this year, as the S&P 500 hit the best levels since last April and more cyclically focused sectors led markets higher late in the quarter on rising hopes for a broad economic expansion.  

However, while clearly the past quarter brought positive developments in the economy and the markets, leading the financial media to proclaim a “new bull market” has started, it’s important to remember that potentially significant risks remain to the economy and markets. Put more bluntly, the market has taken a decidedly positive view on the ultimate resolution of multiple macroeconomic unknowns, but their outcomes remain very uncertain and thanks to the strong year-to-date rally in stocks, there is now little room for disappointment.

First, the economy has not yet felt the full impact of the Fed’s historically aggressive hike campaign, and while the economy has proved surprisingly resilient so far, we know from history that the impacts of rate hikes can take far longer than most expect to impact economic growth. Put in plain language, it’s premature to think the economy is “in the clear” from recession risks, and we should all expect the economy to slow more as we move into the second half of 2023. The key for markets will be the intensity of that slowing, as at these valuation levels stocks are not pricing in a significant economic slowdown.  

On inflation, clearly there’s been progress in bringing inflation down, as year-over-year CPI has fallen from over 9% in 2022 to 4% in less than a year’s time. However, even at 4%, CPI remains far above the Fed’s 2% target. If inflation bounces back, or fails to continue to decline, then the Fed could easily hike rates further, like the Bank of Canada and Reserve Bank of Australia did in the second quarter, following pauses of their own. Those higher rates would weigh further on economic growth.  

Turning to banks, markets have taken the regional bank failures in stride, as the collapse of First Republic Bank caused minimal volatility in the second quarter. However, it’s likely premature to consider the crisis “over” and at a minimum, reduced lending by regional banks poses an additional threat to the commercial real estate market and small businesses more broadly. Bottom line, measures taken by the Fed in March have “ringfenced” the regional bank stress for now, but this remains a risk to the economy.

Finally, markets are trading at their highest valuation in over a year, and investor sentiment has turned suddenly, and intensely, optimistic. The CNN Fear/Greed Index ended the second quarter at “Extreme Greed” levels, while the American Association for Individual Investors (AAII) Bullish/Bearish Sentiment Index hit the most bullish level since November 2021, right before the market collapse started in early 2022. Positive sentiment does not automatically mean markets will decline, but the sudden burst of enthusiasm needs to be considered in the context of what is a still uncertain macroeconomic environment and markets no longer have the protection of low expectations and valuations to cushion declines.  

In sum, clearly there have been positive macro developments so far in 2023 that have helped the stock market rebound. However, it’s important to remember that multiple and varied risks remain for the economy and markets.  

Markets Show Resilience to Start 2023

The S&P 500 ended the first quarter of 2023 with a solid gain as hopes for an economic “soft landing” and the Fed signaling that their historic rate hike campaign is coming to an end helped offset two rate increases and the biggest bank failures since the financial crisis.

Markets started 2023 with strong gains in January, which were primarily driven by a continued decline in widely followed inflation indicators. That decline in price pressures was coupled with surprisingly resilient economic data, especially in the labor market. Those forces combined to increase investors’ hopes that the Fed could deliver an economic soft landing, whereby the economy slows but avoids a painful recession while inflation moves close to the Fed’s target. Additionally, corporate earnings for the fourth quarter of 2022, which were reported in January, were “better than feared” and the resilient nature of corporate America contributed to the growing hope that both an economic and earnings recession could be avoided. The S&P 500 posted strong gains in the month of January, rising more than 6%.    

In February, growing optimism for an economic soft landing was delivered a setback, however, as economic data implied a still very tight labor market while the decline in inflation stalled. The January jobs report, released in early February, showed a massive gain in jobs, implying that the labor market will remain extremely tight (something the Fed believes is contributing to inflation). Later in the month, widely followed inflation metrics such as CPI and the Core PCE Price Index showed minimal further price declines, implying that the drop in inflation that had powered the gains in stocks was ending. The strong economic data and a leveling off of inflation metrics led investors to price in substantially higher interest rates in the coming months, and that weighed on both stocks and bonds in February. The S&P 500 finished with a modest loss on the month, falling just over 2%.

The final month of the first quarter began with investors still focused on inflation and potential interest rate hikes, but the sudden failure of Silicon Valley Bank, at the time the 16^th largest bank in the United States, shifted investor focus to a potentially growing banking crisis. Signature Bank of New York failed just days later, and concerns about a regional banking crisis surged. In response, the Federal Reserve and the Treasury Department created new lending programs aimed at shoring up regional banks and preventing bank runs but concerns about the health of the financial system persisted and those fears weighed on markets through the middle of March. However, while the Federal Reserve hiked interest rates again at the March meeting, policy makers signaled that they are very close to ending the current rate hike campaign. That admission, combined with no additional large bank failures, eased concerns about a growing banking crisis, and the S&P 500 was able to rally during the final two weeks of March to finish the month with a small gain.

In sum, markets were impressively resilient in the first quarter as a looming end to rate hikes, further declines in inflation and quick and effective actions by government officials in response to regional bank failures helped shore up confidence in the banking system. Stocks and bonds both logged modest gains in Q1, despite the threat of a regional banking crisis and still-elevated market volatility.  

First Quarter Performance Review

The first quarter of 2023 saw a sharp reversal in index and sector performance compared to 2022. On an index level, the Nasdaq (which badly underperformed in 2022) handily outperformed in the first quarter and finished with very impressive returns. That outperformance was driven by a decline in bond yields (which makes growth-oriented tech and consumer companies more attractive to investors) and as mega-cap tech companies such as Apple, Alphabet, Amazon and others were viewed as “safe havens” amidst the late-quarter banking stress. The S&P 500, with its heavy weighting to tech, finished the quarter with a solidly positive return while the Dow Industrials and Russell 2000 logged more modest, but still positive returns through the first three months of the year.

By market capitalization, large caps outperformed small caps, as they did throughout 2022. Concerns about funding sources, should the banking crisis worsen, and higher interest rates weighed on small caps as smaller companies are historically more dependent on financing to maintain operations and fuel growth.   

From an investment style standpoint, growth handily outperformed value which is a sharp reversal from 2022. Tech-heavy growth funds benefited from the aforementioned decline in bond yields and a late-quarter “flight to safety” amidst the regional banking crisis. Value funds, which have larger weightings towards financials, were weighed down by concerns about a potential broader banking crisis.

On a sector level, seven of the 11 S&P 500 sectors finished the first quarter with a positive return. Notably, the three top performers from the first quarter were the three worst performing sectors in 2022. Communication services was one of the best performing sectors in the first quarter thanks to strong gains from internet-focused tech stocks, as lower rates and the rotation to mega-cap tech companies pushed the sector higher. The technology sector also clearly benefitted from those two trends, as it rose slightly more than the communications sector in Q1. Finally, consumer discretionary, which has larger weightings towards tech-based consumer companies such as Amazon and others, also logged a solidly positive gain thanks to the same general tech stock outperformance and as the labor market remained more resilient than expected, improving the prospects for consumer spending in the months ahead. 

Turning to the laggards, the financial sector was the worst performer in the first quarter as the regional banking crisis weighed on bank stocks and financials more broadly. Energy also logged solid declines through the first quarter as growing concerns about global economic growth and subsequent weakness in consumer demand weighed on energy stocks. More broadly, the remaining S&P 500 sectors saw small quarterly gains or losses, as there remains a lot of uncertainty about future economic growth and earnings and the banking stresses that emerged in March will only add an additional headwind on economic growth.  

US Equity Indexes	Q1 Return	YTD
S&P 500	7.50%	7.50%
DJ Industrial Average	0.93%	0.93%
NASDAQ 100	20.77%	20.77%
S&P MidCap 400	3.81%	3.81%
Russell 2000	2.74%	2.74%

Internationally, foreign markets largely traded in line with the S&P 500 in the first quarter and realized positive returns. Foreign developed markets outperformed the S&P 500 through the first three months of the year as economic data in Europe was better than expected and European banks were viewed as mostly insulated from the U.S. regional bank crisis. Emerging markets logged slightly positive returns through March but underperformed the S&P 500 thanks to still-elevated geopolitical stress, as U.S.-China tensions rose following the Chinese spy balloon affair.  

International Equity Indexes	Q1 Return	YTD
MSCI EAFE TR USD (Foreign Developed)	8.62%	8.62%
MSCI EM TR USD (Emerging Markets)	4.02%	4.02%
MSCI ACWI Ex USA TR USD (Foreign Dev & EM)	7.00%	7.00%

Commodities saw sharp declines in the first quarter thanks mostly to the notable weakness in oil prices, which hit fresh 52-week lows. Oil fell during the first quarter on rising global recession worries and subsequent reductions in demand expectations, while geopolitical risks didn’t rise enough to offset those demand concerns. Gold, however, posted a solidly positive return as investors moved to the yellow metal as a store of value amidst the regional banking stress.  

Commodity Indexes	Q1 Return	YTD
S&P GSCI (Broad-Based Commodities)	-4.94%	-4.94%
S&P GSCI Crude Oil	-6.15%	-6.15%
GLD Gold Price	8.00%	8.00%

Switching to fixed income markets, the leading benchmark for bonds (Bloomberg Barclays US Aggregate Bond Index) realized a positive return for the first quarter of 2023, although bonds were volatile to start the year. The Fed signaling an imminent end to rate hikes combined with concerns that the regional banking crisis would raise the odds of a recession, fueled a broad bond market rally in the first quarter.

Looking deeper into the fixed income markets, longer-duration bonds outperformed those with shorter durations in the first quarter, as bond investors welcomed further declines in inflation and reached for long-term yield amidst an uncertain outlook for future economic growth.

Turning to the corporate bond market, higher-quality investment grade bonds and higher-yielding, “junk” rated corporate debt registered similarly positive returns in the first quarter. Investors moved to both types of corporate debt following declines in inflation and as corporate earnings results were largely better than feared.  

US Bond Indexes	Q1 Return	YTD
BBgBarc US Agg Bond	2.96%	2.96%
BBgBarc US T-Bill 1-3 Mon	1.09%	1.09%
ICE US T-Bond 7-10 Year	3.55%	3.55%
BBgBarc US MBS (Mortgage-backed)	2.53%	2.53%
BBgBarc Municipal	2.78%	2.78%
BBgBarc US Corporate Invest Grade	3.50%	3.50%
BBgBarc US Corporate High Yield	3.57%	3.57%

Second Quarter Market Outlook

Markets begin the new quarter facing multiple sources of uncertainty including the path of inflation, future economic growth, the number of remaining Fed rate hikes, and whether the regional banking crisis is truly contained. Yet despite all this uncertainty, markets have proven resilient over the past six months since hitting their lows in October of 2022. So, while headwinds remain in place and markets will likely stay volatile, there remains a path for future positive returns.  

Starting with the regional banking crisis, despite consistent comparisons in the financial media between what happened in March and the 2007-2008 financial crisis, there are important differences between the two periods and regulators have already demonstrated their commitment to ensuring we do not experience a repeat of those difficult days. As we begin the new quarter, there is reason for hope this crisis has been contained. But regardless of whether that’s true, regulators and government officials have proven they are ready to use current tools (or create new ones) to prevent a broader spread of the regional banking crisis, and that’s an important, and positive, difference from 2008.

Looking past the regional bank crisis, inflation remains a major longer-term influence on the markets and the economy, and whether inflation resumes its decline this quarter will be very important for investors and the markets. More specifically, the decline in inflation somewhat stalled in February and March but if the decline in inflation resumes in the second quarter that will provide a powerful tailwind for both stocks and bonds.

Regarding economic growth, markets rallied on the hope of an economic soft landing earlier in the first quarter, and while the regional banking crisis complicates that optimistic outlook, it is still possible. To that point, employment, consumer spending and economic growth more broadly have remained impressively resilient, so while we should all expect some slowing in the economy this quarter, a recession is by no means guaranteed. If the economy achieves a soft landing that will be a material positive for risk assets.

Finally, after one of the most intense interest rate hike campaigns in history, the Fed has signaled that it is close to being done with rate increases, and that will remove a material headwind on the economy. As long as that expectation for a looming end to rate hikes does not change, it’ll increase the chances that the economy can achieve the desired soft landing. 

To be sure, this remains a tumultuous time in the markets. Investors are facing the highest interest rates in decades, the worst geopolitical tensions in years, and a very uncertain economic outlook that deteriorated in the wake of recent bank failures. But while concerning, it’s important to realize that underlying U.S. economic fundamentals and U.S. corporate earnings proved incredibly resilient through the first quarter. And those two factors, steady economic growth and strong earnings, are the real long-term drivers of market performance, not the latest disconcerting geopolitical or financial headlines.  

As such, we are prepared for continued volatility and are focused on managing both risks and return potential. We understand that a well-planned, long-term-focused, and diversified financial plan can withstand virtually any market surprise and related bout of volatility, including bank failures, multi-decade highs in inflation, high interest rates, geopolitical tensions, and rising recession risks.

Successful investing is a marathon, not a sprint, and even intense volatility is unlikely to alter a diversified approach set up to meet your long-term investment goals.

Therefore, it’s critical for you to stay invested, remain patient, and stick to your plan, as we’ve worked with you to establish a unique, personal allocation target based on your financial position, risk tolerance, and investment timeline.