2023 has proven to be an extraordinary year thus far, and there is still a lot of uncertainty for the future. We would like to share our outlook for the remainder of the year, and then take a minute to reflect on the first half of the year and share a few insights that may be of interest.
2nd HALF OUTLOOK
As we begin the second half of 2023, the economic and market environment seems to be a mix of caution and optimism. The global economy has shown some resilience recovering from the pandemic-induced downturn. We continue to see the consumer spend as it draws down the savings accumulated during the pandemic. Along with consumer spending, the ongoing pricing power of companies, which although moderating recently, continues to support economic growth, and could lead to a soft landing in the economy.
However, we see those inflationary pressures as a risk to our views as Central Banks continue their hawkish stance. We have seen inflation soften, and believe the tight conditions are filtering into the economy, but it is yet to be seen if inflation will come down to the Fed’s target or if it requires more hikes, more on that topic below. The Fed emphasized in their July meeting that the decision on rates will be data dependent and they will take a meeting-by-meeting approach. We believe that Central Banks prefer to err on the side of being too conservative, and thus expect interest rates to stay high into the first quarter of 2024, even at the expense of a recession.
We anticipate this continued hawkish tone from the Fed and other Central Banks to add to market volatility until inflation shows more signs of retreating with or without a recession. We do believe recession will eventually occur in late 2023 or early 2024. We see a tight labor market as a governor on the pace of the slowdown, and thus a linchpin to the trajectory of the correction. If companies hold on to employees, the slowdown might be gradual. Otherwise, if layoffs increase, it could be more pronounced. Geopolitical tensions and trade disputes continue to be another worry that we are monitoring closely.
We foresee the slowdown in earnings growth will continue and believe a recalibration of multiples could happen, at least until the uncertainty around the global economy, inflation, interest rates and earnings are resolved. Even if Q3 signals the resumption in earnings per share (EPS) growth and companies deliver on the 7-8% EPS growth expected over the next twelve months, we believe the multiple expansion we saw in the first half is over and could potentially act as a headwind to returns. We expect low single digit returns for the S&P 500 in the second half. Both within the US as well as internationally, we have an overweight to those factors and areas that look attractive on both a relative and an absolute basis. Diversification and active risk management will continue to be crucial in these volatile and uncertain times.
We continue to be excited about the opportunity in fixed income. Bond yields offer the best risk adjusted yields compared to equities in nearly 15 years. This cycle has been somewhat different in that long-term yields never managed to reach the highest levels of short-term yields, but generally long-term yields peak before the Federal Reserve is done hiking. That may have been what happened in October of last year. Our base case is for the 10-year treasury yield to trend slightly lower to 3.50% by the end of the year. Even though we do expect some widening in investment grade credit spreads, we expect high quality fixed income to still do well because of the higher yield and the long duration nature of the asset class. We expect High Yield to be more challenged as credit spreads are the tightest they have been in over a year and corporate defaults are just starting to pick up. Next year, nearly $400 BN in high yield debt comes due up from $225 BN this year.
As risks persist, our portfolios are positioned to withstand the volatility. We continue to like our conservative bias, with value, quality and dividend growth stocks anchoring our equity positions, and long duration and higher credit quality the fixed income side. We will make prudent adjustments as we receive more data and as the environment develops.
1st HALF RECAP
Starting at home, the S&P 500 rose nearly 16% in the first half of the year, the second-best start to the year in the last 20 years. However, market leadership was very concentrated in a couple of sectors and more specifically, a basket of stocks. The “Magnificent 7” as you may have heard them called (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla & Meta), accounted for over 70% of the S&P 500 gains. Tech, as a sector, was up over 40% in the first half and communication service was not far behind, posting a 35% gain. Two sectors, which comprise just under 35% of the S&P 500, accounted for over 90% of the return in the first half of the year. The equal weighted index which, as the name implies, gives the same weight to each stock in the S&P 500, was up just 6% over the same period. Domestically, 2023 has seen a resumption of the trades that have worked for the past decade. Large cap beat small cap, growth beat value.
As we analyze the market returns the two main drivers of are earnings per share (EPS) and the multiple that investors are willing to pay for earnings (price-to-earnings ratio). Some secondary drivers we use are cash flows and sentiment. In the first half of the year, earnings expectations rose just 1% while the price-to-earnings was up 15%. The two metrics combined provided the total return for the S&P 500 in the first half. However, historical data tells us that multiple expansion is incredibly hard to predict and typically mean-reverting.
Global developed markets followed the US higher up 12% for the first half while Emerging Markets were only up 5%. The dollar impact on international markets was negligible in the first half of 2023. The greenback traded mostly sideways, closing out the first six months down less than 1%.
Curve inversion deepened this year as front-end interest rates moved higher and longer-term interest rates moved lower. The 7-year treasury was nearly unchanged acting as the pivot point. To this point, 2023 has seen a downshift in the magnitude and pace of Federal Reserve interest rate hikes though all eyes continue to remain on the Federal Reserve. Despite the continued rate hikes bonds made money in the first half of the year with the Barclays Aggregate up 2.0%, municipal bonds up 2.7% and investment grade corporates up 3.2%. The broad commodity basket was down over 10% through June led by a decline in the price of crude oil.
Taking a deeper look at each component of the Fed’s dual mandate, the chart below illustrates, both headline and core CPI have declined to date. As the year began CPI was still increasing at 6.5% year-over-year (yoy). Through June the CPI is now only increasing at 3.0% yoy. Though Core CPI (which excludes food and energy) has declined at a slower pace, if the expected decline in the housing component of CPI comes through this summer, we should be closing in on the Fed’s target inflation target by the end of the year. That being said, the Fed has reminded us several times that there is still more work to be done on inflation. We have long believed the Federal Reserve and their policy actions were not the cause of higher inflation. However, it was the Federal Government who spent over $5T through Covid which accomplished the “helicopter money” effect that Ben Bernanke, former Fed Chairman, referenced in a 2002 speech. An influx of cash in consumer’s accounts coupled with limited supply due to the economic shutdown because of COVID led to the high inflation we are experiencing now.
While the Fed’s primary focus has been bringing inflation back to more acceptable levels, labor market tightness remains a close second. While the labor market is still very tight as a result of the number of workers permanently leaving the job market after the pandemic, the trend in monthly payrolls is moving lower and June saw the lowest monthly number, outside of pandemic distortions, since 2019. As a result of the lack of labor supply, employers have increased wages to attract or retain workers. This has been one more effect that has contributed to the increase in consumer spending and prices in the first half of the year.
Starting in December of 2022, the Federal Reserve decreased the magnitude of their rate hikes from 75bps to 50bps. That trend continued in 2023 at the February, March, and May meetings where the Federal Open Market Committee (FOMC) increased interest rates only 25bps, bringing the Fed’s target to a range from 5.00%-5.25%, the highest level since 2008. Then in June, the Fed held rates steady followed by a 25bps hike in July moving the target to a range of 5.25%-5.50%. As the Fed continues to watch inflation and employment closely, the market continues to try to anticipate the Fed.
At Custos, we are of the belief the US economy cannot sustain interest rates this high for an extended period of time. The Federal Reserve has indicated as much in their economic projections that their target rate will come back down despite not projecting a recession. The interest on the federal debt is up 28% from a year ago. In 2023, the US government will spend more on interest than the country will spend on national defense. Mortgage rates are more than double what they were less than two years ago. The cost of margin lines and lines of credit against portfolios have tripled in many cases. Credit card interest rates are the highest in history at more than 20%. It takes time for rates to filter through the economy. For example, a business that took out a five-year loan in 2019 does not care about higher interest rates until the maturity comes due in 2024. However, when the loan comes due, unless the company can pay the debt off in full, the debt will need to be refinanced at a higher interest rate which instantly lowers profitability. In the US alone, $910B of corporate debt has or will come due in 2023 and another $1T a year through 2026 will also mature.
A quick side note on the housing market since we have written about it in the past and because of the significant impact it has on inflation. As expected, new and existing home sales fell as interest rates shot up in 2021 and 2022. In early 2022, several home builders slowed their land acquisitions and even sold some of their holdings based on the assumption home sales would stay low as long as rates remained high. It is true that sales volumes in the residential real estate market have been abysmal, but an interesting phenomenon has been playing out. While buyers of existing home sales, which typically make up 85% of home sales in a given year, fled the marketplace, so did sellers. The absence of willing sellers provided an opportunity for home builders to fill the void. So, while existing home sales are down 25% from pre-pandemic levels, new home sales are higher than they were in 2019. We suspect this trend will continue until homeowners are forced to sell as a result of financial stress or because interest rates come back down to a more affordable level.
The views expressed in this newsletter represent the opinion of Custos Family Office, a Registered Investment Adviser. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment or services. The information provided herein is obtained from sources believed to be reliable, but no representation or warranty is made as to its accuracy or completeness. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. Investments are not a deposit of or guaranteed by a bank or any bank affiliate. Please notify Custos Family Office if there have been any changes to your financial situation or investment objectives or if you wish to impose or modify any reasonable restrictions on the management of your accounts through Custos Family Office.