2023 First Half Review and Outlook
The S&P 500 continued to rally in the second quarter, led by technology and artificial intelligence stocks, gaining 8.74% and finishing the first half of the year up 16.89%. The strong returns were driven by a reduction in inflation; allowing the Federal Reserve to pause interest rate hikes at their June meeting. Questions remain about the durability of the U.S. economy, inflation and future corporate earnings. At Virtue Asset Management, we believe second half returns will be subdued. We recommend that clients prepare for higher volatility in the remainder of the year and when appropriate raise cash to cover upcoming distributions.
The Consumer Price Index (CPI) increased 4% from May 2022 to May 2023. The increase of 4% was the lowest year over year change since March 2021 (2.6%). The decrease in the inflation rate was enough to convince the Federal Reserve to pause interest rate hikes in June. As we discussed last quarter, we thought investors would position in equities in anticipation of future rate cuts. In the chart below, the 12-month forward price to earnings ratio (P/E) has decoupled from the inverse of the 10-year real yield. To justify the current P/E ratio, equity investors are expecting future interest rate cuts. Currently, the market is expecting the target range of interest rates in June 2024 to be 4.5% to 4.75% and in December 2024 to be 3.75% to 4%.
Currently, the federal funds target range is 5% to 5.25%. When the target interest rate is above the inflation rate, this is considered restrictive monetary policy. This restrictive policy should help lower the inflation rate but can also have the side effect of restricting growth in the economy. Despite pausing in June, the Federal Reserve projected another two quarter percentage point increases by the end of the year. At Virtue Asset Management, we believe the Federal Reserve feels comfortable talking tough against inflation when the stock market has shown strong gains. If the Federal Reserve follows through with the tough talk and raises interest rates to the 5.5% to 5.75% range that will increase the chances of a recession and a decrease in earnings.
The U.S. economy and job market continue to be resilient in a higher interest rate environment. They are some warning signs for the second half of the year. Barclays estimates that the restart of the student loan payments could create a monthly headwind of $15.8 billion – $190 billion a year. This could add pressure on retail and travel spending. Congress passed a debt ceiling bill that allows the Treasury to issue between $1 to $1.3 trillion in debt this year and the Federal Reserve is still cutting back its bond portfolio by approximately $95 billion per month. Both actions will lead to a contraction in the money supply and a headwind to economic growth. With interest rates around 5% Treasury debt provides an attractive alternative to investors compared to the stock market.
The S&P 500 return of 16.89% was powered by a select group of stocks concentrated in the technology sector. The technology heavy Nasdaq Index, fueled by an interest in artificial intelligence, was up 31.73% in the first half. According to Goldman Sachs, the 15 biggest companies in the S&P 500 have driven 86% of the return in the U.S. year to date. The 15 biggest companies are up 34% year to date while the median company is just up 1%. A major question for the second half of the year will be if more stocks can join in the rally. Some analysts are concerned over the long term if 15 stocks can continue to power the overall market. Small cap and international stocks, which have less exposure to technology and AI, lagged the S&P 500 Index.
|S&P 500 Growth||21.25%|
|S&P 500 Value||12.15%|
|S&P MidCap 400||8.84%|
|S&P SmallCap 600||6.03%|
|MSCI Emerging Markets||5.12%|
|Bloomberg US Agg Bond||2.09%|
|iShares iBoxx $ High Yield Corp Bd||4.72%|
The U.S. unemployment rate continues to be near all time lows. In May, the unemployment rate was 3.7%. The strong job market has helped the U.S avoid recession. The revised real gross domestic product (GDP) increased 2% in the first quarter and the Atlanta Fed GDPnow estimate for the second quarter is 2%. With the positive economic growth, earnings estimates for the S&P 500 in 2023 are at $217 a share – a 10% gain from 2022. The forward price to earnings (P/E) ratio using $217 earnings is approximately 20. Earnings estimates for the S&P 500 in 2024 are $244. Using the current P/E of 20 would provide a target of 4880 for the S&P 500 in 2024 – an increase of approximately 10%. At Virtue Asset Management, we believe several factors could slow the short-term growth of earnings. We recommend most clients raise cash to cover distributions through the end of the year.
Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results.
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Virtue Asset Management is neither an attorney nor an accountant, and no portion of this content should be interpreted as legal, accounting or tax advice.
This letter is not intended to be relied upon as research or investment advice. The information presented is as of the date noted and may change as subsequent conditions vary. The information contained in this letter are derived from proprietary and nonproprietary sources deemed by Virtue Asset Management to be reliable. Additional information about Virtue Asset Management is available in its current disclosure documents, Form ADV and Form ADV Part 2A Brochure, which are accessible online via the SEC’s investment Adviser Public Disclosure (IAPD) database at www.adviserinfo.sec.gov, using CRD#283438. Virtue Asset Management is neither an attorney nor an accountant, and no portion of this content should be interpreted as legal, accounting or tax advice.