- Equity and fixed income markets have had a strong first half of 2023
- Historically, equity momentum from the first half of the year has continued in the second half
- Macroeconomic risks persist and could serve as headwinds to the equity rally
- As always, focus on your long-term financial goals and work with your financial advisor to make sure your plan can withstand market volatility
Global equity and fixed income markets have regained their footing in the first half of 2023 after a dismal showing in 2022. In fact, stocks have recovered much of their prior year losses. Bond returns have been less impressive, but price movements have certainly moderated, a welcome development for conservative investors. Heading into 2023, most market strategists expected weak capital market returns early in the year and further improvement in the back half. Instead, we have seen strong equity markets in the face of ongoing concerns over impending recession. So, what has gone right? What can we expect in the final six months of the year? We will attempt to answer those questions in this article and will highlight some potential speed bumps to watch out for.
First, let’s recap what has happened so far this year.
After declining about 20% in 2022, the S&P 500 is up nearly 17% through the end of June. The index bottomed in October and has now produced three straight quarterly gains. The same mega-cap growth names that underperformed in 2022 have been driving the rebound. These companies are heavily featured in the NASDAQ Composite Index, which is off to one of the best year-to-date starts in its history. The stock rebound has not been limited to domestic markets only. International developed markets, as measured by the MSCI EAFE Index1, have gained 12%. The EAFE includes French and German stock markets, which are touching new all-time highs. The Japanese NIKKEI Stock Market Index2 has hit its highest level in 33 years so far in 2023. Emerging markets, meanwhile, have lagged but still produced positive returns.
Fixed income markets, still reeling from one of their worst years in history, have also rebounded. The Bloomberg US Aggregate Bond Index3, a broad measure of investment-grade domestic bonds, is up around 2% through June. The index still has a long way to go before recouping the losses of 2022 (-13%!), but improving yields have given investors a reasonable alternative to stocks for generating total returns.
What’s Gone Right?
Quite a bit, actually. The economy has been stronger than expected and the much-anticipated recession hasn’t yet materialized. Corporate earnings have declined, but not by as much as previously feared. Consumer balance sheets remain strong as cooling inflation has allowed people to pad their savings. The residual effects of stimulus spending and a robust labor market have provided fuel for spending on travel, pickleball gear, and Taylor Swift concert tickets. An awakening to the current capabilities and future possibilities of artificial intelligence has lifted investor enthusiasm, and this has translated into higher earnings projections and loftier valuations for companies in multiple industries.
Let’s take a closer look at the key drivers of capital market growth in 2023:
The economy continues to perform better than most analysts expected. GDP in the first quarter chugged along at a 2% annualized rate. The labor market continues to add hundreds of thousands of jobs each month. Year-over-year inflation has fallen for 11 consecutive months, the longest stretch since the 1920s. Consumer spending, which accounts for two-thirds of US GDP, has remained strong. The housing market may have bottomed out in 2022 and is likely to begin contributing to growth again soon. Construction of new homes is up on a year-over-year basis now for the first time since April 2022. This has boosted homebuilder sentiment at the fastest pace in history outside the initial COVID recovery.
Excitement over Artificial Intelligence (AI)
AI has already begun to transform companies in various industries, and investors are betting that we are only seeing a fraction of its long-term potential. AI has the potential to improve productivity, which could boost profit margins, and ultimately, corporate profits. Public interest in AI exploded after the release of viral chatbot ChatGPT in the fourth quarter of 2022. By January 2023, ChatGPT had become the most widely downloaded app in history. Now, it is difficult to find a single Fortune 500 company that isn’t publicly embracing AI. According to Bank of America, mentions of AI during corporate earnings calls was up 83 percent in the second quarter compared to a year ago:
It is important to recognize, however, that the corporate earnings boost that AI may potentially provide hasn’t happened yet. Interest in AI has resulted in higher expectations for corporate earnings, but these predictions are far from certain.
Of course, simple narratives can’t explain every capital market development. The extent to which any one factor is responsible for positive stock returns is anyone’s guess. In addition to the factors we’ve discussed above, markets have benefited from a rebound in investor sentiment, a "hawkish pause” by the Fed that gave investors hope for lower rates by the end of the year, and the general tendency of markets to rise over time (especially after bear markets).
With half the year now behind us, what can we expect in the second half of 2023? We dislike making short-term market predictions, but we can use history as a guide to help us set reasonable expectations and understand the possibilities.
Do continued gains typically follow strong stock market performance in the first six months of a calendar year? Historically, the answer is yes. According to Carson Investment Research, when the S&P 500 is up at least 10% by midyear, it has finished higher over the next six months 82% of the time. The average index return for the 2nd half of the year has been 7.7%. These continued gains generally persist into the following calendar year as well, with returns midway through the following year totaling 12.2%.
This may seem surprising since we’ve already captured more than the average annual return of the S&P 500 so far in 2023. However, markets tend to be trend following. Strong market returns may encourage more investors to participate, pushing valuations even higher. Historically speaking, it has been wise to remain invested after a strong start to the year.
Remaining invested in years like 2023 has been the smart move historically, but it is important to recognize potential challenges for the market. As we discussed previously, equity markets tend to fall as the economy slips into a recession, and that still seems to be a likely possibility. Many of the leading indicators for a slowing economy are present today, including:
- Yield Curve Inversion. The rate on short-term Treasury bonds is currently higher than the rate on longer-term Treasury bonds. Yield curve inversions have historically been reliable indicators of impending recessions. Treasury yields first inverted in 2022, meaning the recessionary signal has been flashing red for quite some time and the clock is still ticking.
- Housing Slowdown. Although the housing market seems to be rebounding, it is following a huge decline in new and existing home sales in 2022. The magnitude of the housing decline in 2022 suggests the overall economy will follow suit.
- Higher Interest Rates. The pace of interest rate hikes since early 2022 has been one of the fastest on record. The good news is that investors can now earn a decent return on their safe assets. The bad news is that higher rates ultimately lead to higher costs of capital and lower spending by consumers and business. The longer the Federal Reserve keeps interests rates at their current levels, the more obvious the negative economic effects will be.
- Tighter Bank Lending Standards. After the mini-bank crisis in March and April resulted in some of the largest bank failures in US history, banks have tightened their lending standards to ensure their balance sheets remain sound. Like other concerns on this list, there is a lag effect that may begin to affect the economy in the second half of the year.
- Something Unexpected. Many economic risks are obvious and are well-anticipated by market participants. Oftentimes, it is not the expected risks that lead economies into recessions, but rather the unexpected surprises. There have been several examples of these surprises over the past few years, including the COVID pandemic and the Russian invasion of Ukraine.
Investors have enjoyed a solid rebound in global equity and fixed income markets so far in 2023. In all likelihood, these gains will persist through the end of the year. Of course, it’s important to focus not only on the next six months, since short-term market volatility is unpredictable and influenced by a variety of forces. Instead, take time to revisit your financial plan with your financial advisor, who can help ensure that your plan still aligns with your long-term financial goals and can withstand short-term bouts of volatility that the market can provide.
1. The MSCI EAFE Index is designed to measure the equity market performance of developed markets (Europe, Australasia, Far East) excluding the U.S. and Canada. The Index is market-capitalization weighted.
2. The Nikkei is short for Japan's Nikkei 225 Stock Average, the leading and most-respected index of Japanese stocks. It is a price-weighted index composed of Japan's top 225 blue-chip companies traded on the Tokyo Stock Exchange. The Nikkei is equivalent to the Dow Jones Industrial Average (DJIA) Index in the United States. Source: investopedia.com
3. The Bloomberg U.S. Aggregate Total Return Value Unhedged, also known as ‘Bloomberg U.S. Aggregate Bond Index’ formerly known as the ‘Barclays Capital U.S. Aggregate Bond Index’, and prior to that, ‘Lehman Aggregate Bond Index,’ is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).
*Tim Giampetroni is a non-registered associate of Cetera Advisors LLC, and an Investment Adviser Representative offering advisory services through Cetera Investment Advisers LLC, a Registered Investment Adviser.
The views stated in this piece are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities. Due to volatility within the markets, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.