By AJ Loughry, CFA
After a painful year of negative equity & fixed income returns in 2022, markets have experienced a strong rally thus far in 2023. The S&P 500 advanced over 16% during the first half of the year as hype surrounding advances in Artificial Intelligence (‘AI’) led to significant gains for technology-oriented businesses, helping to offset negative sentiment driven by regional bank runs. Whether this is a bear market rally or the start of a new bull market for equities has become a popular debate, with the bulls so far winning the argument. However, the risks of tighter financial conditions, continued regional banking stresses driven by commercial real estate troubles, and sticky inflation causing a higher for longer stance from the Fed remain apparent.
While the S&P has seen strong headline performance, the underlying drivers of this performance appear far less robust. The vast majority of market performance has been generated by a subset of 8 megacap & technology-oriented stocks while the remaining 490+ names in the index have seen much more muted performance. This is highlighted by the divergence in performance of the S&P market-cap weighted index (of which these names comprise nearly 30%) which returned over 16% and the equal weighted index that returned just over 6%. The dramatic outperformance from this subset of names had led to the S&P trading at a forward PE of 19x, with the megacap-8 trading at a multiple of 31.0x compared to 16.5x for the remainder of the index. In order for this equity rally to continue its momentum, a widening of market breadth into the small cap & value sectors may be needed.
Despite repeated calls for an impending recession in the United States, economic activity has stayed resilient throughout the first half of the year. Broad based economic data has strongly beat expectations in the US, highlighted by continuing decreases in headline inflation, Q1 real GDP growing at a 2% annualized rate, the unemployment rate remaining below 4%, and a strong recovery in housing activity despite elevated mortgage rates. On the other hand, economic activity has been much more disappointing in Europe & Asia, and inflation in the Eurozone has proven much stickier. This has been a driver of strong domestic outperformance vs the international developed & emerging markets, with the MSCI EAFE Index up 12% and MSCI EM Index up just 5%.
Fixed Income markets have seen positive performance in 2023 as well despite underperforming equity markets. After seeing a strong drop in yields following the regional banking volatility in March, longer-dated yields have moved back to pre-SVB levels as bank deposits recovered and resilient economic activity has forced the Fed to continue hiking rates. A lack of weakness in labor markets may force the Fed to keep their foot on the brakes, potentially raising the possibility of a hard landing if tighter financial conditions continue to weigh on the global economy.
Source: Bloomberg Barclays, MSCI; FY2022 as of 12/31/2022.. For Equities & Fixed Income, YTD 2023 as of 6/30/2023. For Alternatives, YTD 2023 as of 5/31/2023.
Equity markets have seen a strong recovery in 2023, led by domestic megacap companies with exposure to the adoption of Artificial Intelligence technology. Domestic indices have led global and international markets due to a higher concentration of tech companies that saw extremely strong performance. In addition, the US economy is proving to be far more resilient than their European and Asian peers, helping to drive outperformance. Fixed Income markets also saw a recovery to start 2023 but to a much lesser extent than equities. The continued strength of the US economy has led the market to price in higher Fed Fund rates and delayed the expectation for rate cuts, partially negating the income generation from the sector.
Source: Bloomberg; FY2022 as of 12/31/2022;. YTD 2023 as of 6/30/2023.
The sector winners of 2023 continue to be those most beaten down in 2022; the growth-oriented sectors of IT, Consumer Discretionary, and Communication Services. While the prospects of rate cuts have not yet materialized, these sectors have benefited from their exposure to the adoption of Artificial Intelligence with the 8 biggest names in the S&P seeing some of the strongest performance to start 2023.
U.S Equity Style & Market Capitalization Returns
Source: Bloomberg; FY 2022 as of 12/31/2022. YTD as of 6/30/2023.
Unsurprisingly given the hype surrounding AI, large-cap growth has been the strongest performer YTD in 2023 and has driven headline index performance. Mid and Small Cap growth stocks have also performed well, while the value style has lagged. Cyclical and small-cap equities have lagged in 2023 as a flight to quality has led to investors avoiding exposure that could be impacted in an economic slowdown. Regional banks have had an outsize impact on the Small and Midcap value space as bank failures drove investors to avoid the industry.
Equity Market Dispersion
The S&P 500 has had a strong start to the year, but this performance has not been widespread. Following the collapse of Silicon Valley Bank in March, a significant divergence has emerged between the market cap and equal-weighted indices. The 8 largest contributors to the S&P’s performance (listed on the next page) drove over 73% of the gains despite comprising less than 25% of the index, causing the major divergence above.
Source: Yardeni Research
The strong performance of the S&P has led the index to trade at a forward PE multiple of 19x, above the long-term average of 16.5x but below the levels seen in 2020 and 2021. However, this move higher has been concentrated in the 8 largest names in the index that trade at a 31x multiple. Exclusive of these 8 megacap names, the S&P’s forward PE ratio is 16.5x. While the broader markets’ valuation looks more attractive, these stocks are typically less resilient and more cyclically sensitive than the megacap names that have driven index performance.
Inflation Continues to Move off Highs
Turning to economic data, the Fed remains focused on its fight against inflation. Headline inflation has continued to move strongly off of the highs set in 2022, driven in large part by decreasing energy & goods prices. However, core inflation is proving to be much more stubborn. Bolstered by resilient service spending and shelter costs, core inflation remains above 5%. While market participants have consistently referenced the lagged nature of shelter costs in core CPI, surprisingly resilient housing & labor markets may keep this figure elevated for longer than expected.
US Economic Resiliency
In addition to labor & inflation, broad-based economic data has strongly beaten expectations in the US, as highlighted by the Citi Economic Surprise Index. A much stronger than expected Q1 GDP print, recovering housing data, and resilient manufacturing & service activity has continued to drive a resilient US economy.
On the other hand, international economies have seen much weaker economic data. After benefiting tremendously from a warmer-than-expected winter, European economies have seen strong misses on data readouts including elevated inflation and weak manufacturing activity. A weak Chinese recovery has added to the data misses from European economies that rely on exports to the country.
Moves in the Treasury Curve
The resiliency in US economic activity has led to an expectation for additional rate hikes from the Federal Reserve relative to the end of 2022 in order to quell inflation. These expectations can be seen by the strong move higher in the front end of the treasury curve. The longer end of the treasury curve has moved higher in recent months as well, reversing the move lower in March following the regional banking stresses. Long-term inflation expectations remain well anchored, but attention will continue to be paid to longer-dated yields.
Asset Class Analysis
The strong rally in the first half of 2023 has put the S&P500 at about 7 percent off its late 2021 highs, recovering from its 18% loss last year. This performance came despite material bank pressures and still rising rates, as consumer spending more than offset these challenges. However, businesses continue to get more defensive as liquidity and credit availability have deteriorated. A recession may be on the horizon, but even without leaning into that possibility, we think higher valuations, declining capex by businesses, and slowing spend by consumers will be headwinds to further market appreciation and thus think it opportune to take these early gains and diversify into more defensive, income-producing assets to create resiliency in portfolios.
We reiterate that high valuations do not leave enough margin for error, notably as interest rates will likely remain high, thus the hurdle for riskier investments is also higher.
Value versus Growth: We maintain a relatively balanced approach to Value versus Growth styles, but with a slight bias to Defensive portfolios that are only modestly cheaper than their core benchmark but exhibit greater business resiliency. These managers would be more protective in a market sell-off, but lag in a market rally.
Large versus Small: We complement our Large Cap Defensive exposure with selective, active small- and mid-cap funds. Small caps tend to be more economically sensitive, so we look to be more valuation-conscious in this segment.Domestic versus International: We maintain an overweight to Domestic stocks, based on the quality of businesses and depth of capital markets in the US. We have modestly reduced that overweighting with the addition of a Defensive International strategy. We are modestly underweight Emerging Markets.
Fixed Income: Over-weight
We are Over-weight fixed income via a barbelled approach of investment grade bonds (for some income generation but to also serve as an equity market hedge) and floating rate credit (with attractive income distribution in a higher rate environment and still benign default experience) to complement and diversify away from stocks. The traditional fixed income allocation is highly liquid and can be quickly reinvested into other opportunities that may present themselves in a more challenged market. Floating rate debt exposure is currently offering equity-like return potential while moving up in capital structure seniority and reducing overall portfolio volatility versus equities.
Interest Rate Sensitivity: We had extended our duration as the Fed raised rates throughout 2022. We may have another 25-50bps in hikes coming in 2023, but believe a 5%+ interest rate environment can easily absorb them without suffering material impact to performance. Additionally, if a recession were to come sooner and more severe than anticipated, rate cuts would follow, which would be most beneficial to longer-term bonds. The inverted yield curve makes it challenging to buy 4% 10-year bonds, versus 5%+ 1-year debt, however floating rate and investment grade credit spreads more than compensate for that difference.
Credit Quality: We seek to maintain an overall investment grade credit quality in our liquid fixed income exposures, however would balance this positioning with illiquid direct lending and structured credit investments that exhibit strong equity-like returns despite lower volatility. We are currently limiting this high yield exposure to alternative credit strategies and private investment opportunities that are less sensitive to daily flows and mark-to-market variability.
Liquid Alternatives: Target-weight
Hedge Funds: Under the surface of strong performance from the megacap equities is greater volatility and opportunities for price discovery across asset classes, particularly smaller stocks and credit. This is creating a ripe opportunity for diversified and long/short hedge funds. Strategies that can take advantage of short-term pricing dislocations can offer return enhancement and better resiliency to bouts of volatility. We are exploring specialized lending opportunities that are complementary to traditional direct lending while diversifying away business cycle risk.
Real Estate: We have been adding core-plus real estate opportunities, notably in residential assets for its inflation aligned properties and as a complement to stock and bond portfolios.
Illiquid Alternatives: Target-weight
Valuations adjusted lower, following public market declines in 2022. Committed capital for opportunistic deployment over the next few years should make this vintage of fundraises highly attractive.Secondaries and Distressed investing strategies may benefit well from a slowing economy as they tend to be opportunistic buyers of good assets at discounted valuations, during a period of market uncertainty. The next couple years may be an attractive time to be an opportunistic buyer of real estate assets that may be unsold or facing refinancing pressures. We are diligencing cross-asset special situations strategies in a drawdown format that can take advantage of illiquidity induced volatility.
About AJ Loughry, CFA
Mr. Loughry joined Simon Quick in the summer of 2018 following his graduation from St. Bonaventure University. As a Vice President on the Investments Research team, he is responsible for the monitoring of previous investments, as well as quantitative, qualitative, and operational due diligence on a variety of new investment opportunities. AJ frequently participates in meetings and calls with prospective and existing managers. Lastly, Mr. Loughry is a member of the Hiring Committee, where he helps to identify and interview new talent for the firm. At St. Bonaventure University AJ received bachelor's degrees in Finance and Accounting, graduating Summa Cum Laude. During his time at St. Bonaventure, AJ was a manager of SIMM, a student-run investment fund with a portfolio of over $300,000. To learn more about AJ, connect with him on LinkedIn.
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