Most of us wait for fireworks this time of year, but we have had our fair share of pyrotechnics throughout the first half of 2023. Back in January I posted a piece on LinkedIn highlighting the challenge of forecasting and commented “I would find it more plausible (and interesting) if someone had the courage to say the market is likely to be up 30% or down 11% over the next 12 months…” Well at the midpoint we are halfway to the former and altogether praying that we don’t experience the latter.
Here is a quick summary of where the major indices closed out the first half of the year:
S&P 500: 16.89%
Russell 2000: 8.19%
MSCI EAFE: 12.07%
MSCI Emerging Markets: 5.30%
Bloomberg Barclays Aggregate Bond Index: 2.21%
Between spy balloons, a mini banking crisis toppling 3 large banks, mutiny in Russia, and a listless Chinese economy it seems miraculous that the market continued to climb the wall of worry that it first started climbing back in October. Should that remain the cycle low, after a brutal 9 month bear market that started last January, it would be right in line with the length of the average duration of a market drawdown of 20% or more. It’s nice to see the indices in the black this year, but there is still some ground to make up. After all, when you are down 32.54% as was the Nasdaq last year, you need to go up about 48% to get back to where you started.
What propelled the market’s gains, you ask… Surely the excitement about all things artificial intelligence created some excitement and the companies seemingly most exposed to the “new frontier” saw dramatic increases in share prices. The likes of Nvidia (NVDA) and Meta Platforms (META) saw triple digit gains that would be great returns over a decade occur in the span of less than six months. We’ll see if those gains are here to stay, true these companies have actual earnings and are creating new markets and driving share, but prices can at times detach from reality. Aside from direct AI exposure, companies benefited from the focus on “efficiency,” a gentler way of describing cost cutting mainly in the form of layoffs and pared down CAPEX. Acknowledging that there is a human toll there, keep in mind the market is an emotionless discounter of future cash flows and fiscal restraint within industries not known for penny-pinching has been cause for celebration. You need less top line revenue growth if you can shrink the expenses on your income statement. As the top line has held up despite the calls for the imminent recession rattling around the average Wall St economist echo chamber.
Staying on the topic of earnings for a moment, while we hear of poor market breadth, it wasn’t just 7 stocks that were up on the year. The broader market optimism is directly tied to corporate earnings which have held up quite well in the face of a slowing global economy. In fact if the Atlanta Fed’s GDPNow tracker is accurate, the US may have accelerated somewhat in the second quarter despite a soft manufacturing sector. Should inventories continue to shrink as they are eventually built back up that should lead to a growth tailwind in the coming quarters. Earnings have declined for 2 successive quarters, meeting the definition of an earnings recession, but they have been less bad than initially feared. Here is a simple recap:
4th Quarter 2022: Expected down 3.3%, declined 4.6%
1st Quarter 2023: Expected down 6%, declined only 2%
2nd Quarter 2023: Expected decline 5.6%...
With a low bar, the next six weeks will either fuel further optimism that the market has further room to run up or belie the fact we may have gotten a little ahead of ourselves. All eyes will be on whether or not the second quarter marks trough earnings, so guidance will be worth watching even more than the numbers themselves. An interesting phenomenon has been in place for the last several quarters where companies have been willing and able to lift prices even as volumes declined. If you have further capacity for price increases with the resilient consumer and you have even incremental unit sales increases, margins can expand. After significant multiple compression in 2022 as prices fell sharply and earnings held up, we have seen some reflation here as the market looks ahead to a rebound in earnings cycle.
It seems to some extent the market has moved on from the narrative so goes the Fed and interest rates, so go the major indices. With the tightening cycle nearly coming to a close, with perhaps only 2 more rate hikes (I am doubtful we’ll see two), the ability to start to better understand the impact on borrowing costs should become clearer. Assuming inflation continues to come down, which seems to be in the data pouring in and expected to continue over the next few months when it comes to goods and shelter costs it may mean that by the middle or end of 2024 the Fed can start easing back to neutral territory. With many worrying about the commercial real estate refinancing set for 2025, any opportunity where rolling debt at a lower cost than presently means less likely for collateral damage to the economy. Central bankers are far more likely to be jawboning for the next several months than taking the drastic action we have seen over the last 16 months. On the margin, I think higher rates are a good thing for investors and companies alike, we’ll see rewards accrue to the savers and much more thoughtful use of capital versus using the debt market simply to fuel buybacks as has been the case since after the Great Financial Crisis.
For much of 2023, China has failed to live up to the hype that we saw late in 2022 as investors anticipated the post lockdown China to look a bit like the US. However, the combination of the fact that as a society they are far more aggressive savers than Westerners this due to the lack of social safety nets in place (ironic since it is a Communist country) and the decision on the part of the politburo to channel support to industry versus households during the pandemic has meant an anemic recovery there. Given the likelihood of the payments directly to the households who may have used the funds to purchase iPhones or Nike sneakers it was likely to have less “local impact.” China’s role remains important both in output and the potential for consumption so some thawing in the relationship between the two Super Powers seems inevitable if not altogether welcomed. Much like fracking has marginalized the role of OPEC, there is a chance that the pandemic has created an environment with a broadening out of the supply chain (friend-shoring, on-shoring) may mean Chinese leverage is fading a bit.
Coming into the year, loftier bond yields and cheaper stocks represented a more attractive long term investment proposition. That thesis remains in place today with the 10-year Treasury offering over 4% and the equal weight S&P trading around 15.74 X forward earnings. It’s probably unreasonable to expect the market to have a repeat performance of the first half, but just like I intimated in the difficulties of forecasting then, time to sit back and take it all in.
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