2023 2nd Quarter Market Commentary
Top Headline for Q2: Surging Markets Led by Big Tech
Markets surged again in Q2 – ignoring a “hawkish” Federal Reserve Bank (“Fed”) and slowly deteriorating macro-economic conditions. However, the real story of 2023 requires a look at individual stock performance. The gains in the first half of 2023 can be attributed to a small number of stocks and, more specifically, the Artificial Intelligence (“AI”) craze kicked off by ChatGPT. Chip manufacturers, deemed the biggest beneficiaries of AI, saw some of their best gains ever as evidenced by Nvidia which rose 190% year-to-date to reach a whopping trillion-dollar valuation. Technology, as measured by XLK, gained over 40% in the first half of the year and was led by chip manufacturers along with some familiar “mega cap” names (e.g., Apple, Microsoft, Google and Meta which were up 50%, 43%, 36% and 138% respectively). At quarter end, Apple, our nation’s largest stock, sits at over a $3 trillion valuation.
Shockingly, most of the entire gain for 2023 can be traced to 7 stocks – the 5 above plus Tesla and Amazon. The rest of the market, in aggregate, has gained very little. This divergence has been on full display when comparing “market-cap-weighted” indices (i.e., indices where larger companies command larger allocations) to “equal weight” (i.e., indices where all holdings have the same weighting). The market cap weighted S&P 500 Index (SPY) is up 15.9% year-to-date while the equal weighted version (RSP) is only up 6.9%. At this point, many investors may be wondering why their stock portfolios are not keeping pace with the “market,” as measured by the market-cap-weighted SPY. Most investors shouldn’t keep pace with the market during large surges in either direction. The job of advisors is to reduce volatility through portfolio construction and diversification of asset classes. For example, the 7 stocks above now comprise over 25% of SPY – a dangerous level of concentration and something that shouldn’t be considered a truly diversified portfolio. This type of index concentration has rarely persisted in history and is typically reconciled through a drop in the mega-caps or a relative rise in everything else.
General Market Update
US Equities: The positive 2023 momentum continued in Q2 with the S&P 500 Index up 8.3% during the quarter and the tech-laden Nasdaq Composite up 12.8%. The small company Russell 2000 Index climbed 4.8% and, as would be expected from a mega-cap stock surge, remains well-behind the large-cap indices year-to-date. It’s also interesting to note the divergence between “growth” and “value” stocks. For example, as seen in the chart below with Large Cap Growth in green and Large Cap Value in blue, we’ve witnessed an enormous divergence in these “factors”. We continue to see great opportunities to add value through strategic rebalancing.
International and Emerging Market Equities: International equity markets continue to grind higher but, not surprisingly, continue to lag the tech-heavy U.S. indices. The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was up 3.6% in Q2 and the Schwab Emerging Markets ETF (SCHE) was up 1.0%. Inflation continues to be a substantial problem in developed markets as evidenced by recent central bank rate hikes. The European Central Bank and Bank of England (“BOE”) raised rates in May and the BOE did an unexpected 50 basis point increase in June. Looking outside of Europe, we will be keeping an eye on China in the 2nd half of the year. The economic jolt expected from the “re-opening” provided less of a tailwind than expected. In fact, China’s central bank lowered its short-term funding rate in June for the first time in 10 months suggesting deteriorating conditions.
Fixed Income and Credit: As has generally been expected, bond markets have largely trended sideways as the market anticipated an end to Fed rate hikes. During Q2, market participants seemed to accept the Fed’s “higher for longer” mantra (i.e., expectations changed from rate cuts in 2023 to expecting short-term rates to remain at current levels) and this caused a slight pull back in bond prices/rise in yields.
Commodities, Precious Metals, Inflation: Inflation is falling globally, however, the Fed’s pause coupled with continued hiking in Europe suggests the global developed markets are making less progress. The Fed’s call for “higher for longer” on the rate front has the potential to do economic damage (e.g., increase bankruptcies, lower profits, increase unemployment) which would be very deflationary. Fiscal policy (i.e., the government’s budgeting/spending decisions will also weigh heavily) as continued deficits are inflationary. We remain supportive of pro-inflation assets having a small allocation in portfolios right now, as a hedge against potential global currency devaluation and possible structural inflation led by changing demographics.
A Look Ahead
We have a very interesting story unfolding in the equity markets. We have hints of danger (i.e., one of the most inverted yield curves in history, persistent inflation, rising corporate bankruptcies and a Fed willing to cause economic damage in its effort to combat inflation). However, the U.S. stock market is surging on the promise of productivity gains from advancements in AI – arguably one of the world’s greatest innovations. While it is difficult to predict market moves in the short-term, there is value in capitalizing on volatility through rebalancing and we expect to be busy on this front in the next 12-18 months.
On the rate front, it again becomes a Fed-watching exercise. If the Fed deviates materially from expectations (i.e., 1-2 more hikes with no cuts in 2023) then equity and bond markets are likely to react sharply. We continue to see short-term assets as attractive given the Fed’s actions along with quality longer-duration credit given the potential for cuts over the next several years.