Technology stocks led the markets higher in the first half of 2023. The move surprised many investors since it came on the heels of terrible performance for the sector in 2022. Investors showed a clear preference for the largest companies, including Apple, Microsoft and Nvidia among others. Tech stocks benefited from solid earnings, reasonable valuations when the year began, and a rush into artificial intelligence ("AI") plays. The sector finished up 16.93% for the quarter and 42.06% year-to-date. The next best performing sectors were communication services and consumer discretionary which both ended up more than 30% through June 30th. These sectors also benefited from artificial intelligence plays and better-than-feared earnings as Alphabet, Meta, and Amazon all increased by at least a third in the first half of the year with Meta more than doubling. While the index level gains were robust, no other S&P 500 GICS sector increased more than ten percent in the first half of the year. Five sectors fell, including energy which was the standout performer of 2022 and the only sector to see its price rise last year. 2023 is a new year and falling energy prices contributed to the 7.26% drop in the energy sector through June.
Small and midcap stocks produced strong returns but lagged the S&P 500. The Russell 2000 rose 7.24% in the first half of 2023 while the S&P Midcap 400 increased 7.90%. International stocks produced solid first half returns, but also lagged the S&P 500. The MSCI EAFE Index rose 9.66% while the MSCI Emerging Markets Index increased 3.46%.
After a strong first quarter rebound, the Bloomberg USAgg Index lost 0.84% in the second quarter but is still up a respectable 2.09% through June 30th. The Federal Reserve raised rates twenty-five basis points during the quarter but paused at its June meeting for the first time since it began raising interest rates in March of 2022. The Federal Reserve may still raise one or two more times if the inflation data stops moderating, but it is likely nearing the end of this rate hike campaign.
Gold had a tough second quarter and fell 2.54%, but it is still up 5.23% year-to-date after outperforming bonds and stocks in 2022. Oil prices continued their descent from their 2022 highs and were down 6.65% for the quarter and 11.99% for the first half. The CRB BLS Commodity Index was roughly flat through June 30th. The dollar index edged up 0.40% and is now down a modest 0.59% through June 30th.
Artificial Intelligence Catalyzed Tech Stocks
The S&P 500 increased an impressive 8.30% in the second quarter and is up 15.91% year-to-date. Mega-cap technology and internet stocks led the way. Investors became enamored with the prospects for artificial intelligence after the performance of ChatGPT. Additionally, mega-cap tech continues to generate prodigious amounts of cash despite fears of a slowing economy and an imminent recession. Revenues and earnings growth were strong and came in better than expected after many companies overexpanded in 2021 and 2022.
There is an element of froth in the recent tech rally. Nvidia jumped more than twenty percent after beating revenue and earnings estimates and guiding second quarter revenues higher. However, there is real revenue and earnings potential from Chat GPT for the companies positioned well. Those companies are predominantly mega-cap tech companies. Nvidia’s move seemed hyperbolic, but it raised second quarter revenue estimates approximately four billion dollars when estimates were approximately seven billion dollars before the first quarter report.
The short-term prospects for AI may be overhyped, but the long-term potential is real. AI could be transformative and lead to new revenue streams and operational efficiencies. It may be what is needed to increase productivity growth after decades of decline and offset an aging global workforce. In a problem that predates COVID, many businesses have spent the past half decade struggling to find workers. While the rush into AI stocks may have been overdone in the short-run, NPP expects the revenue opportunities and cost-savings to be significant as the decade progresses.
Another notable component to tech stocks outperformance is that they did it despite interest rates remaining at post-COVID highs. One common market narrative in 2022 was that growth stocks needed perpetually lower interest rates to remain market leaders. For the first half of 2023, that was not the case.
Bond Prices Range Bound
Treasury yields have not moved much from where they started 2023, except for the short end of the yield curve. The yields on ten-year and thirty-year Treasuries are slightly below where they started the year, while the yield on the five-year Treasury Note rose 0.16% as recession fears were pushed out. The rates on one-year Treasuries rose to 5.39% on June 30th from 4.69% at the end of last year. Investment grade and high-yield credit did well as rates stabilized and spreads tightened for most bond sub-asset classes.
The Federal Reserve moved rates from close to zero to just over five percent in a little more than a year. It was roundly criticized for being behind the curve fighting inflation, but now it is time to give the Fed a little credit. Current indications are that the Fed may raise rates once or twice more this year. We think one rate hike should be the baseline expectation, but we’re not sure that will occur. Inflation has come down and is likely to moderate. Short-term interest rates exceed inflation and inflation expectations. Policy works with a lag and so it’s likely that not all the effects of policy tightening have been felt. Even if we are wrong, it is hard seeing the need to raise rates significantly from here.
Treasury investors are now able to earn a real return through fixed income. We believe it is a good time to take advantage although the possibility of imminent rate cuts is not as strong as it once was because the likelihood of a recession has been reduced due to a resilient economy.
Employment Remains Strong
The United States is a consumer-led service economy. Predictable and mandatory spending have contributed to recessions occurring less frequently as the weight of the manufacturing sector waned. Despite softening manufacturing and housing sectors, economic growth was solid in the first half of 2023. One reason is that employment levels have continued to increase in 2023 despite a steep and rapid interest rate tightening cycle. The labor participation rate has increased but it remains on a downward trajectory as the United States ages. There are very few indications that unemployment is about to tick up. Initial unemployment claims have increased off a historically low level but are at a level that historically denoted a growing economy. The Bureau of Labor Statistics reports the quits rate in its monthly JOLTS report. Declining quit rates indicate people are less certain of finding another job. It has decreased but remains near pre-COVID levels. Most labor market data are consistent with an expansion. The data points to a labor market that has moved from very strong to strong. However, it must be noted that labor is a lagging indicator and that it looks good up until the point that it doesn’t, and a recession hits.
Third Quarter Outlook
NPP expects tech stocks to consolidate moving forward. They have run a lot in a short period of time and need to digest their gains. This will leave some but not a huge amount of upside in the S&P 500. The average stock should do better in the second half than the first half, but we do not expect second half returns to be nearly as good as they were in the first half of the year. We think the second half of 2023 will see large stocks with good balance sheets and cash flows outside the tech space do well. NPP expects the Federal Reserve to stop raising rates in 2023. Inflation has moderated and interest rates are now above inflation rates. We expect investment-grade bond investors to be able to clip their coupons, which are much improved over GFC lows. In sum, the second half of 2023 is likely to generate decent returns for investors.