Perspectives

Equity markets were rather flat for the first two months of the second quarter. There was plenty to be concerned about, including fear of an impending recession, weak manufacturing survey data, the lagged effect of tight monetary policy, higher interest rates, and fear of a regional bank-induced credit crunch. Yet, the bulls could rightfully offset these concerns with signs of peak inflation, good corporate earnings, a strong labor market, resilient consumer spending, and improved housing demand. June, however, clearly favored the bulls, as economic data supported the soft-landing scenario. Equity markets were particularly strong for the month, resulting in solid mid-to-high single-digit returns for the quarter.

Large cap stocks were once again bolstered by the strength of mega-cap names within the Information Technology, Communication Services, and Consumer Discretionary sectors. The Artificial Intelligence (AI) growth theme drove the tech-heavy NASDAQ to a quarterly gain of 13.1%. The S&P 500 Index gained 8.7%, pushing its first-half return to 16.9%. It is worth noting that the S&P’s strength has been quite narrow, with only about 30% of its names ahead of the Index. Laggards included the more defensive Utilities and Consumer Staples sectors, as well as Energy, which declined on weak pricing trends. Small cap stocks, as measured by the Russell 2000 Index, finally caught a bid in June, more than erasing its modest losses earlier in the year. Its 5.2% second-quarter gain pushed first-half returns to 8.1%. Sector performance was quite different down cap. While Information Technology remained strong, other leading sectors included Health Care, benefiting from a resurgence in biotech stocks, and the cyclical Industrials sector, which was aided by a better economic outlook and potential for higher spending under the Inflation Reduction Act. Laggards included the defensive Utilities sector and the regional-bank heavy Financials sector.

The market’s growth bias, as evidenced by the outperforming sectors listed above, continued again in the second quarter, especially among large cap stocks. Growth indices led their value-orientated counterparts by a substantial amount so far this year. Style factors generally favored lower-quality characteristics, especially among small caps, with non-earners and low ROE names leading the pack.

The outlook for the economy and the stock market remains decidedly mixed. The heavily inverted yield curve suggests a recession remains the most likely scenario, while most manufacturing survey data remains in contraction territory. Yet, the timing and magnitude of a possible recession remain quite unclear. Several positive factors are worth noting, including better-than-expected corporate earnings reports, a declining rate of inflation, a stubbornly strong labor market, decent consumer spending, and a more buoyant housing market. While these factors did ultimately overwhelm the bears and contribute to the strong market in the second quarter, these are generally lagging or coincident indicators. The bearish case revolves around leading economic indicators where the impact on the economy has yet to be felt. Such factors include restrictive monetary policy, higher interest rates, and tighter lending standards driven by the regional banking crisis. In addition, while the Fed has finally taken a pause in pushing up interest rates, they have also made it clear that a couple more rate increases are in the cards. How this all plays out will generally be determined by the resilience of the economy in the face of these headwinds, and whether encouraging signs of disinflation will continue until we are down closer to the Fed’s stated 2% inflation target.

We were premature in taking down earnings estimates last quarter, and have raised our expectations of S&P 500 earnings back to $210. Yet, given the strength of equities, the market now sells at about 21.2x 2023 earnings estimates, or an earnings yield of 4.7%. Given the continued rise in interest rates, with the 10-year Treasury bond now yielding over 3.8%, the ratio of equity to fixed income yields now stands at a rather low 1.2x.

As we get deeper into this economic cycle, our focus on quality only becomes more important, as 1) quality companies sell at more reasonable valuation levels as they have had a difficult time keeping up with the broader market averages, and 2) companies with quality attributes such as strong management teams and leading market positions tend to do best in periods like this where the outlook is anything but clear.