Quarterly Review and Outlook - July 2023

Dear Clients and Friends,

I am an old man and have known a great many troubles, but most of them never happened.

A famous Wall Street adage says the stock market climbs a “wall of worry.” We’re not sure when the phrase was first coined, but its meaning is simple: stocks often rise during periods of economic turbulence, even when investor sentiment is hounded by fear, uncertainty and doubt. Indeed, the S&P 500’s surprising strength this year (up more than 15% through the end of June)[1] comes amid waning GDP growth expectations, still-rising short-term interest rates, and a plethora of other data that can best be described as a “mixed bag.” It’s little wonder then that a Sentiment Survey ofindividual investors was decidedly bearish in 33 of the 35 weeks that followed the market’s bottom last October, turning bullish this June only after the bulk of the rally had occurred, according to the American Association of Individual Investors.[2]

Can the market continue its upward climb? Let’s look at a few of the bigger bricks in the wall of worry to see if we can gain some insight. In no particular order:

1. The market’s weak breadth casts doubt on the rally’s underpinnings. Much of the recent strength has been driven by a few stocks in the index, mainly in the technology arena, thanks to burgeoning enthusiasm for all things “AI.” While such concentration may pose a risk, we note that the rally did broaden somewhat in June, with the equal-weight S&P 500 index outperforming the more commonly referenced capitalization-weighted variant during the month.[3] We typically avoid concentration in client portfolios (as prudent risk management dictates!), and while our large-cap US equity holdings – be they funds or individual stocks – are benchmarked against the cap-weighted S&P index, we’d like to see the broadening strength continue, with a rising tide lifting all boats.
2. Interest rates are still moving higher, raising the cost of borrowing and reducing asset values. Though the Fed took a breather last month after ten consecutive rate increases, Chairman Powell has indicated additional hikes are in the works. Still, the Fed is surely closer to the end of the rate-hike cycle than the beginning, with the Fed Funds lending rate now above the CPI inflation rate for the first time since 2019.[4]  And don’t forget, higher rates can be very good news for fixed-income investors, especially those who emphasize short-term bond investments – as we have done for client portfolios.
3. Inflation remains well above the Fed’s 2% target level. However, by most measures inflation has declined, and dramatically so. The latest reading has the Consumer Price Index running at a 4% annualized rate, the slowest pace in over two years, well below the 9% peak seen this time last year.[5]

Other bricks of worry include China’s sputtering post-Covid economic recovery; the bleak commercial real estate environment and potential for loan defaults in that market (a risk to banks still reeling from this year’s mini-crisis); recent manufacturing data which showed the eighth consecutive monthly decline in US manufacturing activity;[6] and the inverted US Treasury yield curve, often a harbinger of recession.

Ironically, even good news can be a cause for concern. The ADP Employment Report released this week showed private US employers added a remarkable 497,000 jobs in June, more than double the expected amount.[7] The robust labor report has some market participants concerned the Fed will raise rates higher than is currently forecast and underscores the likelihood of another rate hike later this month.

We can add many more items to the list of troubles, as Twain might call them. But here’s the important point: the market knows of these troubles already. Historically, the market has been reasonably efficient at discounting the likelihood that worries become actual obstacles to growth. Sometimes the market is surprised, as it was in 2022 by sky-high inflation numbers, which led it to over-anticipate a severe recession and collapse in corporate profits. (Neither of those happened, at least not yet.) In the more recent environment, the surprising strength in corporate earnings, consumer confidence and the labor market have supported the market’s move higher, more than outweighing the many troubles etched into the wall of worry. 

Trouble ahead, trouble behind, and you know that notion just crossed my mind.

We began the year anticipating somewhat higher volatility in the financial markets, concurrent with our expectation of slowing economic growth. Instead, other than some wild gyrations caused by liquidity issues at a small number of regional banks, and despite the handwringing and gnashing of teeth associated with the debt ceiling debate, the stock market has been relatively tranquil so far.  And, even as short-term interest rates have moved higher with each Fed move, the US Treasury yield curve is about where it was at the start of the year.

While we remain cautiously optimistic for the balance of 2023, we would not be surprised to see an uptick in volatility as the year progresses. There are still many reasons for worry, and we remain vigilant to changes in the economic and market outlook. We recognize there are uncertainties to any outlook and surprises may yet happen, in the markets and in our personal and professional lives. As always, we encourage you to reach out at any time to discuss your portfolio to ensure your mix of assets is appropriate and aligned with your financial goals.

With best wishes for the coming quarter,

Mitch Schlesinger
Chief Investment Strategist

 

[1] SPGlobal.com, “US Equities Market Attributes June 2023”