Commentary - Q2 2023
In the second quarter of 2023, the stock market, as represented by the S&P 500 Index, generated a return of 8.7%. The market’s rise in the most recent quarter brough the Index’s return on a year-to-date basis to 16.9%. During the quarter, the S&P Growth Stock Index produced a return of 10.6 % and the S&P Value Index produced a return of 6.6%. On a year-to-date basis the Growth Stock Index returned 21.3% and the Value Index returned 12.2%. Small-cap stocks and mid-cap stocks experienced positive returns as well during the most recent quarter. The S&P Midcap Index returned 4.9% while the S&P Small Cap Index returned 3.4%.
The large cap-growth stock sector of the market was favored by investors as the Fed signaled a pause in its relentless increase in the Fed Funds rate. The key interest rate was raised from 0% percent in mid-March of 2022 to 5% most recently. Rising rates have been detrimental to the valuation of growth stocks that tend to have high price earnings ratios, PERs, which are consistent with an expectation for rapid earnings increases in the future. When the discount rate applied to future earnings rises, the valuation for high PER stocks tends to decline more than the valuation of the market.
At the end of the quarter the PER for the S&P 500 stood at approximately 25 times trailing twelve months earnings. This valuation is above the long-term average of about 19 times trailing twelve months earnings. The consensus forecast for earnings for all of 2023 calls for little or no increase in earnings on a year-over-year basis. The preliminary expectation for the second quarter calls for a decline of as much as 10% on a year-over-year basis. Corporate profits and earnings are expected to rise by the end of 2023 if real economic growth resumes.
The early estimates for real economic growth in the second quarter center on 2%. Real growth in the first quarter was slightly less than 2%. However, there is a wide divergence in expectations for real growth over the near term. Some are calling for a recession to begin by the end of 2023 and negative real growth to persist into 2024. Others are calling for no recession and positive real growth in the 2% to 3% range beginning in the fourth quarter of 2023 and throughout 2024.
The recent slow growth of economic activity is a direct result of the Fed’s effort to reduce the rate of inflation to 2% by raising the fed Funds rate and reducing liquidity. The rate of inflation, as measured by the Consumer Price Index, has declined from a high of about 9% in June of 2021 to slightly over 4% by the end of the second quarter. Important components of the Index have shown a steep decline in recent months. The rate of increase in food prices has fallen from a high of a peak rate of over 13% in August of 2022 to just under 6% in the most recent measurement period. Energy prices which increased at a nearly 40% rate in June of 2022 declined at an 11 % rate at the end of the second quarter.
The run-up in inflation began in the second quarter of 2020. A combination of policies drove the rate of price increase from a near zero rate to almost 9%. The first policy was the shutdown of large segments of the economy as part of a set of responses to the COVID-19 pandemic. The shutdown produced a sharp decline in the output of goods and services. The second policy was a rapid increase in the money supply put in place by the Fed during the shutdown as it sought to prevent a deep recession. Increasing inflation was inevitable as the ratio of money to goods and services increased.
The Fed’s policies put in place after the surge in inflation may have helped reduce the rate of inflation, but they produced unfortunate side effects. The most obvious was a slowdown in economic activity as the money supply was reduced and interest rates were increased. A second but less obvious side effect was an increase in the instability of financial institutions as the Fed’s policies resulted in an inverted yield curve. Short-term rates are now higher than long-term rates. Six-month Federal Government obligations yield about 5.5%, two-year obligations yield 4.9%, and ten-year obligations 4.1%. Most financial institutions carry liabilities with shorter maturities than their assets. When the yield curve has a positive slope, assets carry higher rates than do liabilities. When the curve is inverted the reverse is the case and financial institutions lose money. The SVB failure was, at least in part, a function of the negative yield spread between assets and liabilities.
The Fed has stated it will likely increase the Fed Funds rate further. However, the Fed will be confronted by hard choices soon. Inflation is not below the 2% level the Fed has set as its target, but real GDP growth is well below the historical average of about 3%. Despite seemingly robust job growth, the economy has only managed to add approximately 5.5 million jobs over the last 3.5 years, on a base of 155 million, resulting in a mere increase of about 3.6%. This performance, however, falls short, as job growth has only rebounded slightly above pre-pandemic levels, indicating a weaker overall trend.
Additionally, the growth in real disposable personal income just turned positive on a year over year basis in January of 2023 after remaining negative for the period from April of 2021 until January of 2023. If the Fed chooses to raise rates further, economic growth will weaken likely, and the financial sector will be put at risk if the yield curve inverts further. Unfortunately, the Fed appears to be committed to a policy of lowering real growth to reduce inflation; and more rate increases are likely, all other things being equal.
But all other things are not equal. Fiscal policy is spiraling out of control. The Congressional Budget Office (CBO) estimates that the budget deficit for 2023 to be $1.5 trillion. The CBO is required to make ten year-ahead projections for deficits, and the current ten-year estimate calls for a more than $21 trillion increase in accumulated Federal debt outstanding as deficits average nearly $2 trillion per year. Total debt outstanding is expected to increase from the current $31 trillion to $53 trillion over the ten-year period. Federal Government debt as a percentage of GDP is forecast to increase from the current 97% to 119%.
The $21 trillion question is how will the new debt be funded if the Fed continues to raise interest rates and reduce liquidity? Who will buy the $21 trillion in new debt? The Chinese? If financing is available in international markets, will the Fed then neutralize the resulting increase in the money supply, or will it risk a reemergence of inflation? Buy popcorn. Stay tuned. We are living in interesting times.
Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis
The information contained in this commentary represents the opinion of Affinity Investment Advisors, LLC and should not be construed as personalized or individualized investment advice. The analysis and opinions expressed in this report are subject to change without notice. The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations of economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.