Glass Half Bull
Recap of Q2 2023: US Officially in a Bull Market
US Stocks are officially confirmed to be in a Bull Market, with the S&P 500 rallying 20+% from
the low on October 12th, 2022. As a reminder, stocks dropped -24% in the latest Bear Market
that started on January 3rd, 2022 and lasted roughly 9 months. Recently, the S&P 500 has
continued to post a series of “higher highs and higher lows”, while trading above its 200-day
moving average. The market’s resilience has been impressive considering regional bank failures,
fears of a US Recession, a disappointing China reopening, Debt Ceiling negotiations, and rising
rates. As shown on the right, Bull Markets can last many years and typically are much longer
than Bear Markets. Excluding the current Bull Market, the US has seen 14 different Bull
Markets dating back to World War II – with a median return of 91%.
Volatility in the equity markets has remained surprisingly muted (as measured by the VIX). As a
reminder, the Volatility Index (VIX) measures one-month expected volatility of the S&P 500
using the equity index options. The VIX index closed below 15 for the first time since February
2020, breaking a streak of 835 trading days! Meanwhile, the MOVE Index (which measures
one-month implied volatility of US Treasury market) has remained elevated. This divergence
between the VIX and MOVE is highly unusual. Bond market volatility could be contributed to
the regional banking crisis or fears of a Government default, but these issues were either
contained so far (Banking Crisis) or resolved (raising Debt Ceiling). Ultimately the Bond Market
may be signaling concerns around inflation, further Fed tightening, and tight credit and lending
conditions.
Trust the Bull Market? Leadership Has Been Narrow…
Despite the Regional Banking Crisis, the Nasdaq continued to rally in Q2 and finished the first
half of 2023 up 32.3%. The overall strength in Big Tech this year can be contributed to : 1)
anticipation of a Fed “pause”, 2) a flight to safety during the Banking Crisis, and 3) buzz around
Artificial Intelligence. The introduction of ChatGPT in late-2022 opened investors eyes (and the
entire world) to the potential of AI, particularly around productivity gains. ChatGPT was created
by OpenAI and uses advanced language technology to create human-like responses, original
ideas, and content. Once released, it reached one million users in just 5 days! This is faster
than any other online application in history, including Instagram (2.5 months) and Facebook (10
months). The excitement propelled Growth stocks associated with AI, including Microsoft (who
partnered with OpenAI) and Nvidia (whose GPU chips power AI).
What has made this Bull Market so unique is the bulk of this year’s S&P 500 returns have come
from the seven largest Big Tech stocks (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and
Meta). In fact, these seven names accounted for roughly 75% of the S&P 500’s YTD return (see
below).
Trust the Bull Market? The Rally is Broadening
Despite the narrow rally in the first five months of the year, we have seen bullish signs of the
equity rally broadening in June beyond Growth names. For example, Large Growth surged
20.8% in the first five months of the year, while Large Value (-1.4%) and Small Caps (-0.1%)
were negative. In June, Large Value (+6.6%) and Small Caps (+8.1%) both rallied. Most
reassuring may be the June rally in sectors that are tied to either the strength of the consumer,
such as Cons. Discretionary (+12.1%), or the health of the economy, such as Industrials
(+11.3%). Meanwhile, more defensive sectors have underperformed in June, such as Consumer
Staples (+3.2%) and Utilities (+1.6%).
Equities Historically Rally After the Last Fed Hike
As mentioned last quarter, equities historically have rallied after the last rate hike in a cycle. The
Fed left rates unchanged in June for the first time since January 2022, after a streak of ten
straight meetings with rate hikes. This is one of the longest streaks of consecutive rate hikes,
with the record being 17 straight hikes in the early 2000s. Despite the “pause,” Fed officials all
but indicated they expect 1 to 2 more rate hikes
in 2023, with Fed Chair Powell noting the July
meeting “will be live.” The reason for the
temporary pause was due to the lagging effect
on the economy when raising rates, and for Fed
officials to monitor incoming data. Recently
Powell has indicated policy “may not be
restrictive enough.” If the Fed raises rates two
more times, the Fed Funds Rate would reach a
level of 5.50%-5.75%. According to the CME
FedWatch Tool, the market is currently pricing
in an 89% chance of a 25 basis point hike in July, but just an 18% chance the Fed will hike again
in September (see below chart).
Despite projecting additional hikes, it appears the Fed is nearing the end of its rate hiking cycle.
In looking at the past 30 years (going back to 1994), there have been five prior rate hiking cycles
– including the current cycle. In the prior four cycles, equities rallied in the following 12 months
after the last rate hike (except in 2000 during the Tech Bubble).
Remaining Forces Pressuring Inflation
CPI only rose 0.1% month-over-month in May,
with the year-over-year figure dropping to
4.0%. Falling food prices and stable energy
prices have contributed to the drop in CPI.
Fears over oil shortages proved to be unfounded
despite production cuts by OPEC+ (April) and
Saudi Arabia (June). Despite CPI dropping from
a high of 9.1% last June, Core CPI (which
excludes food and energy) has remained stickier
and caught the attention of the Fed. Last month,
Core CPI rose 0.4% month-over-month and
5.3% year-over-year (from 5.4% the previous
month). The Fed remains adamant that their Fed
Funds Target is 2% and has signaled more
demand destruction is needed to bring down CPI. One potential warning sign for Fed Officials is
inflation re-accelerating, which the UK is currently experiencing.
When we look at the different components of Core CPI versus their year-over-year inflation
rates, Shelter and Owners Equivalent Rent continue to exhibit the most upward pressure on
inflation. New Home Sales recently climbed at the fastest pace in over a year and US Housing
Starts soared over 21% in May. Motor Vehicle Repairs and Transportation Services have some
of the highest inflation rates. In general, Services are less sensitive to interest rates and are still
experiencing structural tailwinds after Covid.
The Bond Market Continues to Signal Warning Signs
Despite positivity in the equity markets, the bond market continues to tell a completely different
story. Yield curves remain massively inverted and signal Recession fears. Normally longer-term
yields are higher due to uncertainty over inflation and interest rates. Currently, however, over
80% of the yield curve is inverted as short-term yields surged over expectations of elevated rates.
Since 1980, every time this number was over 80%, a Recession followed.
Why are Bond Markets so cautious? There are many lingering concerns:
• Tighter Lending Standards as a result of the regional banking crisis and concerns
around the availability of credit to small- and medium-sized businesses
• Commercial Real Estate (CRE) market due to the popularity of “work from home” and
the fact the CRE market depends on loans from smaller banks.
• Stickier inflation and the Fed tipping the economy into a Recession through higher rates.
• Worrisome Economic Data, including eight straight months of the ISM Manufacturing
data in contraction territory (<50.0). The latest reading (46.0) is the weakest level since
May 2020.
Every US Recession since the 1950s has been preceded by an inverted yield curve. The 10-year
and 2-year yield curve is closely watched by investors and is at its most inverted level since the
early 1980s. It is important to note there is usually a delay between the time of inversion and
beginning of Recession. For example, following the inversion of the 10-year and 2-year yield
curve, a Recession historically followed by as little as six months or as much as two years (since
1955). The current inversion began in July 2022.
What this means for the markets
Our original forecast of “higher for longer” rates at the beginning
of the year is panning out. The Fed’s updated Dot Plot shows 1-2
more rate hike in 2023 and then holding rates steady into 2024. The
Fed’s view is still consistent with an “Inflationary Boom” scenario, in
which economic growth continues at a relatively brisk clip with inflation
remaining above the Fed’s target into 2024. The market however seems
to be pricing in a “Deflationary Boom.” Last quarter we favored the
scenario where “banking stresses are successfully contained, the US economy avoids a near-term
Recession, and the Fed doesn’t move aggressively.” We largely still agree with this view, even
thought we expect 1-2 more rate hikes, starting in July.
Maintain positioning in high quality stocks. We are still cautious on this market, given
warnings in the Bond Market, a lack of volatility in the equity markets, and a run up in
valuations (S&P 500 trades at roughly 19x). We believe investors should avoid complacency and
monitor positions and sizes to avoid becoming overexposed to certain first half outperformers,
such as Big Tech and Semis.
Targeted Fiscal Stimulus Will Benefit Certain Industries: $2 Trillion in government spending
will support Infrastructure, including Energy Transformation and domestic manufacturing (i.e.
Semi industry).
There are powerful price and seasonality trends that cannot be ignored. Bull Markets last
much longer than Bear Markets, and we potentially could be in the early stages of a Bull market
that officially started in October 2022. As stated earlier, a strong first half to a year (>10%)
historically leads to strong second half returns. Finally, the 3rd year of a Presidential cycle has
historically produced the strongest equity returns in a four year cycle. On the other hand, Year 2
of a Presidential cycle is the weakest for equity returns.
The US isn’t the only Bull Market: Maintain global diversification. Japan is in the third
longest Bull Market in its history due to loose monetary policy, yield curve control, renewed
foreign interest, and a more shareholder friendly approach by companies. India is another Bull
Market and is one of the fastest growing countries in the world.
US over Developed Europe. The US is closer to the end of its rate hiking cycle than Europe,
which is dealing with sticker inflation (and in some cases accelerating inflation). For example,
the Bank of England announced a surprise 50 basis point hike after Core CPI rose at its fastest
pace since 1992. It’s possible the European Central Bank and Bank of England continue hiking
rates beyond when the Fed pauses. Low Natural Gas prices also have benefited Europe in 2023,
but prices rallied in June.
Don’t give up on Fixed Income, and maintain a barbell approach between US Treasuries &
Credit. 2022 was an extremely unusual year for fixed income, as US Treasuries and Credit
delivered multiple quarters of negative returns together. Historically they move in different
directions, as Government bonds tend to do well when the economy is slowing and inflation is
cooling, while Credit typically outperforms in a growing economy.
