2nd Quarter 2023: Market and Economy

Market and Economy

Stocks enjoyed a remarkable run in the first half of 2023. The S&P 500 posted an impressive 8.7% gain in the second quarter, boosting its return for the year to 16.9%. Though the index still has to rise another 8% to reach new all-time highs, this recent push puts the S&P 500 24% above last October’s lows. Crossing the 20% milestone officially signifies an end to the ugly bear market of 2022 and heralds the start of a new bull market—always a welcome development.

2023: A Year of Growth

The adage “a rising tide lifts all boats” is being put to the test in 2023. Growth stocks started 2023 strong and continued outpacing value in the second quarter. Growth companies tend to be in technology-driven industries prioritizing rapid revenue growth and offer investors high-return potential but also carry higher risk. In contrast, value companies usually are in more traditional, slower-growing industries that trade at less expensive prices and often pay higher dividends. Over the first half of the year, the Russell 1000 Growth Index racked up a staggering 29.0% gain, while the Russell 1000 Value index returned just 5.1%.

Looking more closely at this divergence reveals several factors at play. For one, it is essentially only a handful of the largest technology-focused companies that have created these eye-popping returns. Seven of the largest companies (Apple +50%, Microsoft +43%, Alphabet +36%, Amazon +55%, NVIDIA +190%, Tesla +113%, and Meta +138%) account for nearly all of the S&P 500’s return this year. They have all largely been fueled by optimism surrounding the potential for artificial intelligence (AI) technology to transform the economy, as Benton discusses in his commentary this quarter. According to a recent PricewaterhouseCoopers (PwC) study titled Sizing the Prize, AI could potentially add $15.7 trillion to the global economy by 2030. It’s hard to read that and not get a little excited but the current run-up in prices implies that investors expect these companies to experience significant earnings increases in the near-term. They may be right but we may find that those earnings increases are further out. AI’s impact will no doubt be tremendous; how it will manifest in corporate earnings is yet to be determined. As with the advent of technological changes in the past, it is no surprise that growth investors are jockeying for position, trying to gain a foothold in future growth.

The shifting headwinds from 2022 are another factor in the recent growth/value disparity. To combat high inflation, the Federal Reserve pushed interest rates higher and faster than at any point over the last four decades. The implications of rising rates extended beyond their direct impact on businesses, as they fundamentally altered the equation for valuing future earnings, meaning that stocks of companies with the highest projected future earnings growth were hit the hardest. The real damage, however, was done when the Fed hiked the Fed Funds rate by 4.25% in 2022. The smaller 0.75% increase this year hasn’t packed quite the same punch.

At Bragg Financial Advisors, our investment philosophy favors value investing, which is grounded in the belief that the price you pay for an investment matters. While we still allocate a significant portion to growth, we tilt our overall portfolios toward companies generating higher earnings per dollar invested. Despite our conviction, we haven’t enjoyed seeing our stock portfolios lag in 2023. The view, however, gets better if you look at the whole picture.

As Portfolio Manager Brian Bonewitz illustrated in his May 2023 article, The Counterintuitive Stock Market Strategy: Lose Less, we strive to succeed by minimizing losses. Last year proved to be challenging for almost all investments, but the same growth stocks that are leading this year were the stocks that led the downturn last year. The Russell 1000 Growth Index plummeted 29.1% in 2022, while the Russell 1000 Value Index fared better with more modest losses of just 7.5%. Combining the performance of 2022 and the first half of 2023, the Russell 1000 Value Index still leads with a loss of just 2.8%, compared to an 8.6% loss for the Russell 1000 Growth Index.

Stocks Accelerating While Economy Slows

The Fed, for the first time since January 2022, decided to press pause on rate hikes in June as US inflation continues to slow along with economic growth. As of May, US inflation is down to 4.0% over the past year, per the Labor Department’s monthly report of the Consumer Price Index, well below last summer’s peak above 9%. However, this pause may not signal an end to rate hikes, as inflation is still double the Fed’s 2% target.

But it is not solely the Fed applying the brakes that’s slowing the economy. March bank failures by Silicon Valley Bank and Signature Bank, followed more recently by First Republic Bank, are making it increasingly challenging for borrowers to secure loans. Many small and mid-size banks are reporting prioritizing safer lending decisions, even if it means sacrificing some profits.

Additionally, the early-June agreement reached by Congress and President Biden that thankfully avoided a collision with the debt ceiling may contribute to dampening inflation by modestly curbing future government spending. Moreover, starting in October, debt payments for student loans will resume after a three-and-a-half-year suspension initiated during the early stages of the COVID-19 pandemic under the Trump administration. Ending this policy removes one more source of stimulus, as it allowed money that could have been used to repay student loans to be spent on purchases such as televisions, cars, and vacations.

Recession Watch

As the Federal Reserve continues to tighten monetary policy, as it has over the past year and a half, concerns about a potential recession continue to rise. The primary reason for these concerns is that recessions followed eight of the Fed’s last nine tightening cycles. If interest rates are raised too high, economic activity can grind to a sudden halt, as consumers and businesses think twice before making significant purchases or investments, eventually leading to loan defaults and layoffs. The Fed hopes to achieve a “soft landing” that curbs inflation without triggering severe economic consequences.

So, are we heading for a “rough landing”? The Fed’s decision to pause in June and adopt a wait-and-see approach reflects the difficulty of their task. Most major indicators point to a slowdown in the economy, but the economy continues to be remarkedly resilient, with growth remaining positive. At the very least, this provides a glimmer of hope that, even if a recession does occur in the near future, it won’t be anywhere near as devastating as the financial crisis we experienced in 2008.

Squaring Rising Investor Optimism With Falling Economic Growth

Why is the stock market rising if the economy is slowing? In general, the stock market tends to change direction before the economy. To paraphrase hockey all-star, Wayne Gretzky, “Stocks skate to where the economy is headed, not to where it has been.” Hopefully this means slowing economic growth is already priced in and the market is looking forward to strength on the other side of this period of weakness.

Either way, recent returns fit with historical patterns of an ending bear market and a budding bull market. Undoubtedly, the outperformance of growth stocks could continue, but at some point returns will even out. AI may be the next big thing but with any new technology, advancement has never moved in a straight line. There will be bumps along the way. And the winners won’t just be a handful of technology companies. Better software and smarter operations will help drive rising profits across all sectors.

The first half of 2023 has been a welcome development for investors following a very difficult 2022. It is crucial, though, to approach the future with cautious optimism, hoping for continued gains while preparing for the potential challenges that lie ahead.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.