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Quarterly CIO Commentary – Q3 2023

Is the bull really a bear?

Brian Henderson
This report was prepared by Brian Henderson Chief Investment Officer

In early June, the S&P 500 increased more than 20% from its lows in early October—an increase sometimes associated with a bull market—causing some to wonder if a slower economy isn’t in the cards after all.

Or is it?

The fact is: it’s not uncommon for the S&P 500 to have significant rallies in front of bear markets and economic slowdowns. We saw it in the market run-up in ’99. We saw it in the run-up to the housing crisis, where we had multiple 20%-plus rallies that ended up being short-lived.

Furthermore, it’s also important to keep in mind what’s driving the S&P 500’s growth and the fact that these drivers aren’t necessarily indicative of how equities overall are performing. The stocks of five tech companies—Apple, Microsoft, Amazon, NVIDIA and Google—make up nearly one-quarter of the S&P 500. These five stocks are up much higher than the remaining 495 stocks, which are barely up at all. Much of this can be explained by positive news surrounding the growth of artificial intelligence (AI) and its potential impact on revenue. For instance, the stock of NVIDIA, which makes AI-driven hardware and software, was up near 200% year to date, as of June 21.

Looking more broadly at equity markets, small- and mid-cap stocks also are up in the double-digits but that also has an explanation. When long-term rate expectations come down, as they have been, price-earnings multiples tend to increase and investors tend to be willing to pay higher prices for stocks.

All this is to say, it’s premature to say that the latest rally is a positive portent—especially as the Federal Reserve likely is not done hiking rates, which will slow the economy and, as it does, it’s just a matter of time before equity markets are impacted.

Why market turns do not sway us

Too often, investors take on too much risk when equity market volatility comes down under the assumption that the waters will remain calm. However, history has shown us that periods of low volatility don’t last forever and that sometimes surprises come out of the blue, causing a market downturn and hurting investors who took on too much risk.

And so, any particular turns in the market do not drive our approach to investing. Instead, we look at what the market is giving (as far as potential returns going forward) and what the market is pricing in. Then, we look at how investments will perform under different economic and market scenarios, and the levels of risk associated with these investments. For example, when money market funds are yielding around 5% and high-grade fixed income is yielding around 5% to 7%, that’s very compelling to us because of the amount of cushioning these investments offer when there’s an economic downturn.

What may be ahead this quarter

So, will there be a downturn?

Much of the discussion on what may be ahead has been on the Fed’s efforts to slow the U.S. economy by raising rates—and understandably so. Normally, a rate-hiking cycle of this speed would be enough to drive us into a recession—even though so far, it hasn’t. The Fed’s decision to skip raising the Federal Fund rate in June has given the country a little bit of breathing room, but that might not last long.

Many people (myself included) believe there will be at least one more rate hike this year, especially as inflation remains elevated. Moreover, it’s important to keep in mind that monetary policy operates with a lag, so some effects of the rate hikes are yet to be seen.

But we’ll see one of these effects very soon: Roughly $910 billion in U.S. corporate debt is projected to mature this year, with even more anticipated to mature in 2024. That means that companies will have to refinance this debt at today’s higher rates, compared to near-zero rates when some of this debt was first issued. That will be a tough pill for these companies to swallow, and I expect we’ll see an impact on economic growth.

Consumers’ financial health, too, might change, which is significant for an economy largely driven by consumer spending. As unemployment rises, as it is expected to do as the economy slows to bring down inflation, consumers who lose their jobs may find it difficult to pay their debt. That’s after consumer credit card balances have continued to rise following drop in the early months of the pandemic. Student loan interest will resume Sept. 1 and payments will restart Oct. 1, which also might decrease personal consumption.

However, at the same time, the federal government has been overspending for years at a level normally seen when it’s trying to get the country out of a recession (even though we’re not currently in one). This overspending has given tremendous support to economic growth and is one explanation as to why the economy has held up so well despite the rate hikes.

And given that the debt ceiling resolution doesn’t actually reduce government spending, it’s a tailwind that may be here to stay.

But whether the economy will continue to stay resilient to headwinds such as higher rates remains to be seen—and, as always, we will continue to monitor the situation closely and keep you informed.