Q2 2023 Market Perspective

In June the financial community mourned the loss of an industry pioneer, Nobel Prize winner Harry Markowitz, who passed away at the age of 95. Markowitz’s dissertation on the importance of carefully crafting asset selection to form a more thoughtful investment portfolio went on to become the foundation of modern portfolio theory (MPT). In short, MPT is the framework used to build a portfolio of diversified investments that aims to create a higher expected return at lower levels of risk, and this theory serves as the central tenet of Altium’s investment philosophy. Core to Altium’s philosophy is the importance of designing a diversified and long-term investment strategy which is built around an individual’s unique set of circumstances, while working with our clients to eliminate potential emotional biases from the investment decision process. We thank Harry Markowitz for his monumental contributions to financial investing.

During the second quarter equity markets continued to generate strong returns on optimism surrounding a resilient economy, dissipating concern over the regional bank failures earlier in the year, and U.S. policy maker’s last-minute deal to avoid a national default. The S&P 500 TR index was up 8.7% in the second quarter and is up nearly 17% for the full year as of June 30th. [1] Consumer spending remains the primary driver of economic growth, supported by an unwavering labor market. The second half of the year will continue with a focus on inflation and even though the Federal Reserve (Fed) is now expected to raise interest rates even higher this year, declining inflation results have fostered enthusiasm that the economy may avoid a prolonged recession.

While stock indices broadly appreciated during the second quarter, fixed income assets were mostly unchanged following their strong first quarter performance. The factors that have contributed to strong equity performance, however, lend support to the notion of higher interest rates for a longer than expected period. This has resulted in a bifurcation within the financial markets, where an inverted yield curve continues to reflect the prospect of a pending recession, in direct contrast to the optimism implied with rising stock prices. Where appropriate, we continue to recommend investing in higher quality and moderate duration fixed income assets, which remain an attractive investment based on current levels of yield and feature a lower risk profile relative to equities.

In 1952, when Harry Markowitz penned his research piece, “Portfolio Selection”, he sought to quantify investment risk and opined that investors ought to be as concerned with volatility as they are with expected returns. While always a central theme within our communications, it seems evermore fitting today, given the uncertainty in today’s market, that we lean on the lessons learned from Markowitz and emphasize the importance of adhering to your thoughtfully designed long-term investment strategy. We can anticipate market volatility to pick up again after the summer as we gain clarity on how high the Fed will raise interest rates, how long the Fed plans to maintain its restrictive policy, and whether the economy will enter a recession due to the cumulative effects of such contractionary policy. With the S&P 500 index having delivered high-teens year-to-date appreciation, in large part driven by mega cap growth stocks, we cautiously evaluate the prospect of more muted returns from the index during the second half of the year.

Q2 MARKET RETURNS

Index Returns [1]:

Major Asset Class Returns

INFLATION & INTEREST RATES

U.S. inflation growth has fallen to a two-year low, a major step towards reducing the significant surge in the cost of living which has anguished the country during its recovery from the Covid pandemic. Core inflation (Core CPI), which measures the monthly change in prices paid by U.S. consumers and excludes food and energy prices, increased 4.8% in June (over a one-year period), down from an annual rate of 5.6% back in January. [2] This is certainly a favorable trend; however, the Fed remains committed to a 2% target inflation rate.

Inflation has remained sticky due to continued strength in the recreational and services sectors of the economy. With consumers continuing to spend on items such as travel and dining, the Fed remains in a difficult position. To push inflation lower, the Fed must look to slow down the consumer and the most direct way to impact spending is to weaken the labor market. Therefore, the Fed is likely going to continue to rely on monetary policy tools to contract the economy and has indicated that interest rates will remain restrictive as long as they deem necessary.

The market currently expects the Fed to raise short-term interest rates another 0.25% at its July 26th meeting, which would take the Fed Funds rate to 5.5%, and maintain those levels through the remainder of the year. The chart below shows the trend of CPI over the past 2.5 years, which peaked roughly one year ago, and highlights elevated inflationary levels in the Services sector (red bar).

HIGHER RATES FOR LONGER & THE IMPACT TO THE ECONOMY

The longer interest rates remain at restrictive levels, the greater the probability of an economic recession. The National Bureau of Economic Research (NBER) is the organization responsible for officially declaring when a recession occurs and their definition of a recession is, “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” [3]

To measure the decline in economic activity, NBER will analyze data such as real disposable income, consumer spending, manufacturing, retail sales, industrial production, and labor conditions. Most of these indicators remain modestly above contractionary levels making it hard to predict when we may enter a recessionary environment. While economists and market analysts will debate whether a recession will occur by year end or closer toward the second half of 2024, most agree that it’s simply a matter of time.

Historically, the economy has a lag of 12 to 18 months before it experiences any significant changes in response to shifts in monetary policy, and while the Fed began raising interest rates in March 2022 (or about 16 months ago) it has been about 12 months since the Fed began its aggressive shift in policy. Most importantly, the underlying condition of the economy today is healthy, and given the lack of obvious catalysts developing that may trigger a severe recession, we would not expect a significant economic contraction to occur. However, the longer the Fed must fight inflation, the risks to the economy grow. This uncertainty surrounding inflation, the Fed, and a recession will keep investors on their heels for the foreseeable future.

WHAT IS MARKET BREADTH AND IS IT A CONCERN TODAY?

The top ten stocks by market capitalization in the S&P 500 index contributed more than three quarters of the index’s return through June 30th. [4] When we look at market breadth, we are comparing the number of stocks in an index that are rising, relative to those that are declining or relatively underperforming. In this case, with the mega-cap U.S. digital and tech stocks driving a significant portion of the index’s return this year, some market analysts are concerned that the recent market recovery is too narrowly focused on a few companies (i.e. not broad enough). A key argument is that if these big tech names falter, it would be difficult for the other index constituents to pick up the slack.

There is an ongoing debate among market analysts as to whether narrow market breadth is a bullish or bearish signal of expected near-term returns. As we look out towards the second half of the year, we become increasingly conscious of the S&P 500 index’s ability to find support from the large segment of stocks that have lagged these top performers, including more value-oriented and cyclical stocks. These companies tend to be more sensitive to economic growth and should benefit from any further indication that a recession will be pushed out past 2023 as well as signals from the Fed that they have reached a peak policy interest rate.

Diversification is a core tenet of our investment philosophy and thus limiting concentrated exposure to both individual stocks and market sectors is something that we take into consideration during portfolio construction and portfolio rebalancing. Market breadth is an important factor within our investment committee’s due diligence process, and we continue to monitor recent developments; however, we note that it is common for performance leaders and laggards to rotate often within a market cycle.

SUMMARY

In response to the regional bank turmoil during the first quarter, the Fed’s actions were called into question as to whether they would be able to maintain such a restrictive stance with its interest rate policy. The Fed has been very transparent with its intentions to slow down inflation at any cost, and as a result, expectations for higher interest rates and for a longer period have for the most part been priced into the fixed income yield curve. Meanwhile, stock valuations and earnings projections reflect a more optimistic tone, leading to a bifurcation of messages between the fixed income and stock markets.

Harry Markowitz once said, “diversification is the only free lunch in investing.” While predicting market returns is extremely difficult, he argued that market risk is measurable and should be taken into consideration when constructing investment strategies. The benefits of diversification extend beyond the ability to enhance possible portfolio returns relative to the amount of risk taken. It sets the stage for financial professionals to create risk appropriate portfolios that investors may confidently commit to throughout the ups and downs of a market cycle. 

APPENDIX

Chart A: 2023 Total Return of Major Asset Class Indexes

1 – Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
2 – https://tradingeconomics.com/united-states/core-pce-price-index-annual-change
3 – https://www.nber.org/research/business-cycle-dating/business-cycle-dating-procedure-frequently-asked-questions
4 – Bloomberg data; S&P 500 YTD returns

IMPORTANT DISCLOSURE:

Altium is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Registration as an investment adviser does not imply a certain level of skill or training. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC. This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors. All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Altium and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Altium and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice. This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates. This material was not intended or written to be used or presented to any entity as tax or legal advice. Clients are urged to consult their tax and/or legal advisor for related questions.