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During the second quarter markets seemingly shrugged off the news of a banking crisis and a highly anticipated recession to move forward. In anticipation that earnings would be down, and that additional bad news was coming, many investors were bearish to start the quarter with higher cash levels and lower net exposures. After three domestic bank failures the U.S. Federal Reserve provided a backstop to prevent more potential regional bank failures. We believe this provided liquidity to the markets, which coupled with better-than-expected earnings and artificial intelligence (AI) related excitement helped propel the markets.
In recent months the commercial real estate (CRE) market has garnered increasing investor attention. Over $1.5 trillion of CRE debt is due to be refinanced in the next 18 months and many properties are upside down on their valuation and cost of debt because of the shift in higher interest rates. We may see some defaults in the CRE market, with office properties being especially vulnerable. However, we believe that this environment presents interesting opportunities for those with available capital. Lending to CRE companies is now at double-digit interest rates. Additionally, we are seeing potential opportunities in the public REIT market, which tends to bottom four to six quarters before the private real estate market.
Investors and economists have shifted their perception of a recession. The probability of a recession seems to be greater than 50%, but many now believe that it will be milder, especially relative to what we saw in 2008 and 2020. We have had the fastest Fed rate hiking cycle in history, interest rates are at the highest levels in 15 years and inflation remains above what we have seen for two decades. Stock market
U.S. Equity Markets
U.S. equity indices were positive for the second quarter led by large-cap stocks, then small-cap stocks and finally mid-cap stocks. The best-performing sectors were Technology, Consumer Discretionary and Communication Services. The underperforming sectors were Energy, Consumer Staples, and Utilities.
The excitement of artificial intelligence (AI) is benefitting companies associated with the technology. The enthusiasm has propelled some stocks to new highs and unreasonable valuations. Nvidia, which develops the computer graphic interfaces that are predominately used in AI, guided up second-quarter revenue from $7 billion to $11 billion. Just this year, the stock has increased over 180% and the price to sales is at 40 times. Other stocks like Microsoft have also benefitted from this excitement and are now trading at stretched valuations. The seven largest stocks in the S&P 500 have a combined 31% weighting in the index, showing how much the big technology stocks have run. Our analysts are now seeing the initial increased usage of features like ChatGPT coming down. We believe a bubble has formed related to this theme and we will most likely see some normalization in stock prices.
During earnings season, many companies reported better-than-expected earnings. The price increases that companies passed through over the last several quarters have helped support revenue growth, while falling commodity and freight costs have helped support the cost side. However, for retailers, we saw a large impact from organized theft that has impacted margins and we believe will be embedded in the cost structure going forward.
U.S. Fixed Income
U.S. fixed income price performance decreased for the quarter. As a result of the Feds belief that a recession is not imminent, interest rates continued to shift higher. The short end of the yield curve remains attractive, with yields over 5%. Volatility related to interest rates should be more muted as the Fed winds down expected increases.
We are seeing a pullback in commodity prices following a post pandemic surge last year. This pullback is helping to bring down inflation. Oil prices have stayed relatively range bound around $70/barrel but are down 11% year to date. The home improvement retailers noted a sharp decrease in lumber prices, which are off over 50% from the high. Copper prices have also decreased, despite the demand and need in electric batteries.
The Consumer Price Index reading for May increased 4% year-over-year, which is down significantly from the 9.1% year-over-year increase in June 2022. Declining commodity costs have had an impact on the falling inflation levels. However, this is still above the Federal Reserve’s desired 2% inflation rate, which leaves open the possibility for more interest rate increases this year.
Interest Rates/Fed/U.S. Economy
The Federal Reserve has raised interest rates ten times since March 2022 to combat inflation but decided to pause at its June meeting. The Fed Funds Rate, or the short-term borrowing rate, is in the target range of 5% to 5.25%. However, Fed Chairman Powell has noted that one or two more rate increases are on the table for the remainder of the year. The Fed, as we have noted, is data-dependent, and continues to see overall strength in the economy.
The U.S. economy has remained resilient with positive GDP growth despite higher interest rates and higher inflation levels. However, we are seeing pockets of economic weakness, like manufacturing, with the Purchasing Managers Index (PMI) in contraction levels and many companies are reporting slowing order books. Retailers are reporting that the lower-income consumer is stretched and significantly reducing discretionary purchases. The job market, while a lagging indicator, remains robust and consumers continue to spend. Housing, which pulled back last year, seems to be recovering especially for new homes and with the millennial population forming households. That said, because of the banking crisis lending standards have tightened. We are starting to see increased bankruptcies/defaults, which could ultimately slow the economy.
Despite the persistent high inflation and high interest rates in Europe, the economies are fairly resilient. Economic growth has been revised up modestly for most countries in Europe and their potential recession may be muted as well. Inflation across Europe is coming down except for the U.K., where It has been increasing To combat the inflation both the Bank of England and the European Central bank (ECB) have continued to raise interest rates and have noted that they are not done. Both central banks have a 2% inflation target and at the June meeting the Bank of England raised rates by 50 bps to 5% and the ECB raised interest rates by 25bps to 3.25%.
After China lifted Covid restrictions in December, the Chinese economy grew faster than expected at 4.5% annually as retail sales and industrial production increased. It appears that in the second quarter that the growth has slowed as the housing market continues to decline, exports have declined as a result of supply chains moving to other countries and there is a high level of unemployment among younger workers. Previously, China would inject stimulus into the economy to get it growing, but the government is worried now about taking on too much debt. It is uncertain what growth will look like in the second half of 2023.
While it is difficult to forecast recessions and market pullbacks, as evidenced by the first half of the year, we remain cautious because there is a lag to rising interest rates and their effect on the economy. Parts of the market look expensive right now and the overall market valuation is trending above historical averages, which keeps us cautious in this current market environment. Given the higher interest rate environment fixed income is attractive as well as pockets of asset classes and regions that have been underperformers for a while like public real estate and emerging markets.