|Thayer Commentary – Five Key Questions|
What Happened in the Financial Markets in 2Q23?
Stocks posted strong returns in the second quarter, building on first quarter gains and creating a very solid first half of 2023. The S&P 500 index posted an 8.7% gain in the recent three months, bringing its six-month rise to 16.9%, and crossing a bull market (20%+) threshold from its October lows. The inclusive world measure, the ACWI, posted 6.3% and 14.2% gains over the three and six-month periods. Generally, spirits were buoyed by easing inflation concerns pointing to a visible conclusion of the Federal Reserve’s rate hike campaign, solid corporate performance, and economic readings indicative of slow growth as opposed to recession.
The stock advance was quite narrow, however, with the top ten performers, largely the technology (including AI) and consumer discretionary giants, accounting for an estimated 95% of the S&P’s first half rise. An equal-weighted rendering of the S&P – each stock accounting for the same .2% of the index — showed much more modest single digit gains for the quarter and year. The large tech stock dominance carried the NASDAQ to 13.1% and 32.2% quarterly and first half gains. This however could be viewed entirely as a reclamation of steep 2022 losses, and one that still fell short of the old high ground, with the index ending June still 13.0% under its November 2021 highs.
The quarter proved more challenging for bonds, as interest rates rose across the yield curve, depressing prices, particularly at the shorter end. Shorter rates took their cues more directly from Fed rate policy (as indeed its policy rate is a short-term borrowing rate), with the 2-year Treasury yield rising from 4.06% to 4.87% over the three-month period, not far from the 5.00-5.25% Fed rate. The 10-year Treasury’s yield rose more modestly, from 3.48% to 3.81%, the latter number ending the period more than a percentage point under its 2-year counterpart, suggesting investor caution on longer range economic growth. Overall, total returns were negative in the quarter, the AGG index losing 0.9%, trimming its year-to-date gain to 2.3%.
Are the Economy and Inflation Cooling as Planned by the Federal Reserve?
The final revision for 2023’s first quarter indicated a 2.0% annualized real GDP growth rate, slower than the prior quarter’s 2.6% rate but above the previous revision at 1.3%, and an upside surprise. The main driver has been consumer spending, which rose 4.2% in the quarter, the highest growth rate in two years. Robust job gains paired with solid wage increases continue to provide the octane. Most economists are looking for a 1-2% GDP advance for the second quarter followed by deceleration over the second half, if perhaps short of earlier expectations for recession. The Fed in fact raised its 2023 estimate from 0.4% to 1.1%.
Inflation has come down significantly, the CPI’s May year-to-year rate of 4.0% the lowest since March 2021 and well below the interim high of 9.0% in 2021. But slicing off the last increment to the Fed’s desired 2% neighborhood is likely to be the most challenging. Wages, having risen to around 4% after years mired in the 2-3% range, are by nature sticky, and they represent the largest input in corporate costs, which in turn flow through to prices. This has been particularly true in labor-intensive sectors such as health care, education, hotels and restaurants. The Fed, even with a pause in June on the heels of 5 percent worth of hikes in the prior 15 months, continues to express a wary stance, implying a strong possibility of a restart of rate hikes later this month.
How Troubled is Commercial Real Estate?
The Fed’s aggressive rate hike program is a major headwind for the most rate-sensitive sectors, including the $45 trillion residential real estate and $20 trillion commercial real estate sectors. While the former has been resilient so far (as housing continues to be in short supply), the CRE sector has encountered difficulty, both cyclical (slower economic growth, tighter bank lending and significantly higher rates) and secular (a dramatic three-year shift from in-office work to remote work). Vacancy rates in office buildings have moved up to the high single digits in most major markets and to the high teens in more severely affected cities such as San Francisco, and these figures likely understate the pain, not reflecting upcoming lease expirations.
The best located and newest, most energy-efficient buildings should be able to weather the storm and command top rents, but lesser properties will face tough choices, including whether to invest in major refurbishment, or even more expensive refashioning as residential housing, if zoning permits. All this takes money, while old lower cost debt matures into a higher rate environment, triggering higher borrowing costs. Not surprisingly, valuations are down sharply, 50% or more, in some markets. The hotel/leisure space, more tied to COVID dynamics, experienced a shake-out and severe property mark-downs, but has since recovered.
For both offices and hotels, the challenging environment has separated the best from the rest, while secondary properties will re-price lower, along with their debt. This will pose a challenge to lenders, including regional banks and private equity funders. But at the same time, opportunities at cheaper property prices lie ahead. The best hotel operators arguably emerged from COVID in better shape, having found adoptable efficiencies while operating on a shoestring during the pandemic, and taking advantage of downtime to shut down whole floors at a time to more easily upgrade and remodel. As always, valuations and management quality crucially matter from an investor standpoint.
Can the Ukraine War Find Resolution, and Alter the Geo-political Balance?
The stunning events in Russia in late June – the mercenary Wagner Group mutiny and (uncompleted) march on Moscow, under its leader Yevgeny Prigozhin – raised hopes that both Vladimir Putin’s leadership and the Ukraine campaign would be severely undermined if not curtailed. This may happen, but the malaise and sense of entrenchment in the field of battle remains. Russia’s military clearly has underperformed, prompting the Wagner actions, but Ukraine’s ambitious counter-offensives have proved difficult. Putin seemingly is compromised, and Ukraine President Volodymyr Zelensky has expressed his belief that half of Russia is more aligned with Prigozhin, who at this writing may have re-entered Russia and also possibly met with Putin. There also appears to be apathy and fatigue in Russia, allowing Putin some space. Dictators can survive setbacks. But time will tell.
Perhaps capitalizing on regret in Beijing for picking the wrong horse, with Russia markedly weakened, the U.S. has increased efforts to step into the vacuum and rekindle ties to China. Secretary of State Antony Blinken’s visit last month was followed by a trip by Treasury Secretary Janet Yellen this past weekend with Chinese economic leaders. There were no major breakthroughs in the Yellen talks, and thus tensions continue around treatment of Trump-era tariffs that have remained in place, and delicate technology transfer questions, notably those framed by our Chips Act. The latter is designed to strengthen the U.S. hand in the mission critical semiconductor space, which sets up arguably the most compelling politico-economic issue with China, given Taiwan’s central importance in chip manufacturing. A Biden-Xi summit meeting would be a logical next step.
What are Changes in Portfolio Strategy Positioning, if Any?
With broad stock indices higher and valuations historically now on the richer side, we are not counselling further tactical equity adds. But we are in a process of shifting strategy portfolios toward a mix of traditional equity and bond exposure and progressively downplaying the liquid alternative funds. While we continue to believe active strategies should be included, there will be a shift toward lower cost passive vehicles to provide core exposure. This will provide diversification with regard to both maturity and borrower type in fixed income, and effectively all categories within the equity spectrum.
David Miller | Miller CPA, LLC & Chris Wilmerding | Thayer Partners, LLC
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