We’re at the mid-way point of 2023 and the most anticipated recession in memory still hasn’t materialized, despite concerted efforts by the Federal Reserve to stymie economic growth. Surprisingly, 525 basis points of interest rate hikes have yet to dent the seemingly imperturbable labor market, while the final print for Q1 GDP showed an economy growing at a 2.0% annual pace. After taking a debatable pause at its June confab, the FOMC is likely to resume interest rate hikes at its July 26 meeting, with the futures market currently assigning a 90% chance for an additional 25 basis point move. And yet, despite continued tightening, angst over a pending recession, and a recent surge in interest rates, we find the S&P 500 up +15% on the year, driven largely by a handful of large-cap tech companies.
Just 10 companies account for nearly 90% of the YTD S&P 500 return. Led by Apple (+46%), Microsoft (+40%), Amazon (+54%), Nvidia (+183%) and Tesla (+124%), among others, the advent of AI has unleashed a torrent of investor cash into companies thought to be beneficiaries. Time will tell. The remaining 490 stocks in the S&P have had a very different return experience thus far in 2023, and may hold more value going forward.
This narrow market breadth is eerily reminiscent of 2020, when the so-called “FAANG” stocks soared during the pandemic, as they were considered the main beneficiaries of a locked-down, stay at home society. The bloom came off the rose a bit in 2022 as those FAANG stocks fell by an average of -46%! More recently, the advanced microchip designer NVIDIA, reported a surprise earnings beat for Q2, driven largely by demand for its sophisticated chips powering the Artificial Intelligence surge. NVIDIA’s stock has risen 183% this year, resulting in a market cap just north of $1 trillion. While certainly a great company, an awful lot of good news is priced into that stock.
Large cap technology companies have stolen the show thus far in 2023, as the vast majority of non-tech companies plod along, trading at reasonable multiples with, by and large, reasonable growth prospects. US small and mid-cap stocks started the year strongly, only to be hit when Silicon Valley Bank collapsed back in March. Whereas technology holds an outsized sector weight in the S&P 500, the S&P 600 and 400 have greater exposure to financial services and more domestic-oriented businesses. Despite their recent struggles, we continue to think they present investors with a compelling long-term opportunity.
Perhaps the biggest story of 2023 to date has been the Fed’s ongoing battle with inflation, resulting in the highest bond yields seen in over a decade. As we go to press, the 2-year Treasury note yield recently breached 5%, the highest level seen since 2007. For bond investors, this move in yields has resulted in paper losses, but more importantly the chance to lock in higher yields following a decade+ of Quantitative Easing. Even with the Fed likely to raise short-term rates one or two more times here in 2023, we think Treasury yields above 5% represent a compelling risk-adjusted opportunity for many investors.
Should inflation prove more persistent than currently expected, we would expect to see 5 year, 10 year and longer-dated bond yields rise measurably. At some point unknown, the Fed will have accomplished its goal of slowing the economy, reducing the demand for labor, and squashing inflation. When that happens, history suggests the economy will likely be in or near a recessionary state, and the US central bank will likely be forced to start cutting interest rates. Given the uncertainty around the timing of all this, we think it’s prudent for investors to consider extending duration a bit in their fixed income portfolios, moving gradually from Treasury Bills, out the yield curve to the 2yr to 10yr space, locking in some of these higher yields. Rates may go higher from here, so leaving a little dry powder would be prudent.
Stocks likely won’t react well to significantly higher interest rates and will invariably sell-off at some point, again creating opportunity for those investors with liquidity. The AI renaissance may indeed just be beginning, and the current enthusiasm (and uncertainty) around this space takes us back to the late ‘90’s during the advent of the internet. Invariably there will be winners and losers resulting from AI, and at this point, it is difficult if not impossible to accurately identify those companies, so caution is warranted. Certainly today’s winners look to have a lot of good news priced in, but it’s very likely many under-appreciated names today will prove to be the big beneficiaries if and when AI becomes a widespread commercial opportunity.
Lastly, the time may be upon us when those investors forced to lean more heavily into stocks over the past decade as bond yields plumbed historical lows, may want to consider pivoting back into fixed income. We’re referring here to those in, at or near retirement, who were “forced” by the Fed to allocate more of their portfolio to stocks, than they might have under normal conditions. We recognize everyone’s situation is unique, but this summer might be a good time to reassess one’s investment risk profile, knowing that ultra-safe 5% returns do now exist, and equities are no longer the only game in town (yes, TINA is officially dead).
The U.S. economy appears to be weathering higher interest rates well so far. June’s unemployment rate came in at just 3.6%, with payrolls increasing by 209k, and hourly earnings edging higher by +0.4% on the month. US economic growth is steady, if unspectacular. Q2 earnings season is upon us and we’ll soon see if corporate profits are holding up, justifying today’s elevated equity levels. The bar is set somewhat low so positive surprises may be in store. The IPO window, something of a proxy for investor risk appetite, looks to be gradually reopening after a tough couple of years.
All that said, the Fed appears to have some more work to do. There remains a non-zero probability that it goes too far, and tips the US into a deeper recession than anticipated. Higher interest rates will eventually affect corporate profit margins and default rates will likely rise. Embracing higher quality equity investments and higher quality bonds should help investors manage whatever volatility lies ahead. We continue to balance optimism with realism here at Nottingham, keeping focused on risk as much as return. Please reach out if you would like to speak with our talented portfolio management team. We’re here to help.
Larry Whistler, CFA
Larry joined Nottingham in 2006 and heads the Investment Policy Committee, along with portfolio and relationship management responsibilities. He brings over 32 years of investment experience to the team. Prior to joining Nottingham in 2006, Larry worked as an independent RIA for two years and, before that, spent a decade as a bond trader for Merrill Lynch Capital Markets in Los Angeles and New York City.
Nottingham Advisors offers both institutional and individual clients experience, sophistication, and professionalism when helping them achieve their goals. With over 40 years of serving Western New York and clients in more than 30 states, Nottingham tailors each solution to fit the specific needs of each client.
For more information about Nottingham’s offerings, visit www.nottinghamadvisors.com or call 716-633-3800.
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