The Rear View and the Front View
The first half of 2023 is squarely in the books. On a price basis, year-to-date results have varied considerably across capital markets. In the U.S., for example, the S&P 500 was up 16% in H1, the Dow was up 4% in H1, and the NASDAQ Composite was up 32% in H1. In Canada, the S&P/TSX Composite Index was up 4% in H1, though most of this positive return came in the first quarter. Bond markets in Canada and U.S. were up about 1% on a price basis in the first half of the year, though bonds now offer the most attractive yields in many years.
In short, both the economy and equity markets have proved fairly resilient in the face of an aggressive central bank tightening cycle globally. We note that it’s not uncommon for stocks, in particular, to endure a tightening cycle well until the very late stages, as the reason for higher interest rates in the first place is very strong aggregate demand putting upward pressure on inflation.
Nonetheless, central bank leaders seem confounded by the resilience of the economy and the persistence of inflation, as evidenced by some of the statements they made at their June central bank forum in Portugal. Put simply, central bankers are struggling to understand why inflation isn’t slowing more quickly after the biggest and fastest rate hikes in a generation.
In our view, two things have been fundamentally different this time around vis a vis prior rate-tightening cycles 1) the large buffer of excess savings on household balance sheets that was the result of very easy fiscal and monetary policy during and after the pandemic and 2) the ongoing lack of labour supply to meet demand, largely driven by deaths and retirements (sometimes early) as a result of the pandemic.
While there is no hard and fast measure for excess savings on household balance sheets, the San Francisco Fed does calculate an estimate that suggests the vast majority of U.S. excess household savings are now depleted. Furthermore, we’re beginning to see a little softness in labour markets (witness last Friday’s lower-than-expected June payrolls report in the U.S.). The cumulative wear-and-tear on the economy, caused by higher prices and higher interest rates, is starting to show up in the numbers. Given the stickiness of core inflation and the long and variable lags of prior central bank rate hikes, we expect the economy will continue to lose steam in the next few quarters. Equity markets, on the other hand, seem to be signalling a more resilient economy ahead, but for this, one needs to dive deeper into the averages.
The first-half strength in the S&P 500 was driven by a handful of mega-cap equities. While the S&P 500 is up 16% in H1, the average stock in the S&P 500 is up only 6% in the same period. We note that this “performance concentration” is not without recent precedent. In the 2021-2022 period, the S&P 500 was up ~30%, but excluding the mega-cap FAAMNG stocks, it was up a whopping 0%. Thus, narrow market participation by a handful of mega-cap technology names is hardly a new phenomenon.
The H1 outperformance of the “Mega-Cap 8”, largely driven by the promise of artificial intelligence (AI), has overshadowed the underperformance of the “S&P 492”, carrying the S&P 500 to a strong start for the year. We’ll be watching carefully to see what choice the broad market makes next – either the S&P 492 will catch up to the Mega-Cap 8, or the Mega-Cap 8 will fizzle. For us to have higher conviction that this is really the beginning of a new bull market, we’ll need to see much broader participation among sectors and stocks.
For what it’s worth, we believe the market ultimately resolves to the downside, in other words, we think that the current FOMO rally in the Mega-Cap 8 will give way to recession and market correction. It just may take longer than most expect. We sense a complacency among market participants because a recession has yet to arrive, after so much talk about it coming. Many now dismiss the possibility of recession, and we think that’s dangerous, though perhaps the market is not yet complacent enough to set up for a capitulation. Equity markets may yet levitate further as the last bearish holdouts throw in the towel, one by one.
All that said, central banks are poised to keep raising interest rates into a slowing global economy, and equity market valuation is high, particularly in the U.S. With the S&P 500 now trading at a rich 19x forward earnings, the risk/reward trade-off (at the index level) is not attractive to us in the short term, especially if earnings estimates revise downward and credit conditions deteriorate further. However, as always, we are seeing some specific opportunities, both current and emerging, and we’re acting accordingly.
Our Core Model Portfolios
Our core model portfolios underwent some material changes in Q2, but not in our fixed income allocation. As was the case a quarter ago, our model portfolio bond allocations continue to have a bias to higher-quality and longer duration. While central banks might have a couple more rate increases in their back pocket, we maintain the view that today’s risk-adjusted return potential on bonds remains attractive given the current economic backdrop.
In Q2, we significantly reduced gold exposure in our model portfolios. With central banks still raising rates and inflation falling (albeit slowly), real interest rates are firmly in positive territory, which is quite negative for gold in the near term. Technically, the USD-denominated gold price formed a triple top, and cannot seem to move sustainably above $2,000/oz.
We also reduced our real estate and infrastructure exposure (both interest-sensitives) in Q2, and we’re now seeing better prices for those assets and preparing for a potential re-entry into certain names.
Finally, given the year-to-date outperformance in U.S. equities, we reduced our U.S. equity exposure toward the end of the quarter, and added further to our global equity allocation, particularly in Developed Asia-Pacific and Emerging Markets.