Market Navigator – July 2023 edition

Market Navigator

July 5, 2023

This monthly publication provides regular and timely economic and investment strategy views.

Monthly letter

As we pass the midpoint of the year, it’s a good time to reflect on how the economy and markets are progressing relative to our expectations, adjustments made along the way, and our outlook into the second half.

Taking a step back, after being very bullish during the early stages of the market rebound coming out of the pandemic, we systematically moved to a more defensive posture starting early in 2022 given heightened concerns around the Federal Reserve’s (Fed) aggressive stance, inflation, and global growth.

In general, this positioning worked out; however, coming into 2023, we overstayed our welcome on the defensive side, as the markets, economy, and earnings have thus far proved more resilient than our initial expectations.

In early June, as noted in last month’s publication, we upgraded equities to neutral. We did this as the S&P 500 broke above the 4200 level, forward earnings trends improved, investor positioning remained overly depressed, the economy appeared less interest rate sensitive relative to the past cycles, and our view on valuations and the market evolved. Thus, we neutralized our positioning across stocks, bonds, and cash in our House Views. That’s where we stand today.

Coming into the year, a key theme of ours was to keep an open mind. We have believed and continue to see that the traditional playbook is challenged in this post-pandemic world, where the crosscurrents remain extreme.

From excess consumer savings, which are still buffering the consumer, to the switch from goods to services, to the unemployment rate still hovering around a 50-year low despite the most aggressive Fed rate hiking cycle in decades, to the unlikely recent strength evident in the housing market, despite mortgage rates crossing back above 7%, the environment appears unusual. In fact, homebuilder stocks, typically thought of as one of the most interest rate sensitive areas, just made a record high and are up 48% this year alone. Quite unusual, indeed.

Then, when reviewing the S&P 500 returns this year, the index achieved those gains in an unusual way.

  • The tech sector rose 43% in the first six months of the year, and just 10 stocks account for more than 78% of the S&P 500’s return. We have the most concentrated market in at least the past 40 years.
  • Despite three Fed rate hikes, valuations for the S&P 500 have expanded to among the highest levels of the past 20 years, outside of the pandemic and tech bubble. That’s not what one would normally expect with the Fed still in tightening mode.
  • This speaks a lot to the gains in tech. We expect tech to maintain a premium valuation given the need for companies to invest even if the economy slows, as expected, or risk being left behind.
  • The average stock, as proxied by the S&P 500 Equal Weight Index, has a forward P/E of 15x, only slightly above where it started the year.
  • Corporate profits are thus far holding up better than feared. Forward 12-month earnings estimates are at an eight-month high, once again showing the adaptability and resiliency of Corporate America.

While we neutralized our tactical position to reflect the crosscurrents and respect for the market’s upward trend, we still don’t see this as the start of a runaway bull market, like 2009 or 2020.

Starting points are higher for valuations, and policy support from the fiscal and monetary side, which often provides the liquidity to support a strong and sustained uptrend, is constrained given the scar tissue of elevated inflation of the past year and elevated debt levels.

The lagged impact of the aggressive rate hikes of the past year and the Fed maintaining a higher-for-longer rate policy will likely still have an impact on the economy. Additionally, with the highest yields in more than a decade, fixed income and cash are providing more competition for equities.

As we sit today, the bar seems high to us to move from neutral to offense as opposed to defense over the next six to 12 months, but as always, we will follow the data and keep an open mind.

“…coming into the year, a key theme of ours was to keep an open mind. We have believed and continue to see that the traditional playbook is challenged in this postpandemic world…”

Positioning and a look forward

Although being underweight equities earlier in the year proved wrong-footed, our style preferences within equities have generally been additive. Our long-standing bias for the U.S over international markets is aiding us as is our large cap preference relative to small and mid caps.

Heading into the second half, we are maintaining this position. That said, after one of the most extreme periods of underperformance of the past 30 years, we see a relative opportunity in the S&P 500 Equal Weight Index. We are staying tactically neutral small caps with the macro cycle working against these stocks, though for longer-term investors, valuations are attractive, and stocks are oversold.

The international developed markets have pulled back, and valuations are attractive. Therefore, we are comfortable with slightly higher exposure than where we were coming into the year, but we still see these regions as less attractive compared to the U.S. given our view of a slowing global economy and the more cyclical nature/sector exposure of these markets.

We are still largely negative on emerging markets, where China accounts for almost a third of the index, relative earnings and price trends are weak, and geopolitical risks remain elevated.

With yields hovering around the highest levels of the past decade, we see value restored in fixed income. From a portfolio ballast and income level perspective, high quality fixed income remains a key focus. Credit markets, in our view, are just not compensating investors enough for some of the macro risks out there.

I will end this month’s publication the same way I ended our 2023 outlook – “So, yes, there are things that are different this cycle. It will be important to remain flexible and follow the data."

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