Setting the scene
The economic challenges that characterised 2022 weighed heavily on the investment outlook going into 2023. Prevailing predictions pointed to an impending global recession, causing concern for risky assets. Contrarians in turn argued that the overwhelming negative consensus meant that even a lack of bad news rather than a positive catalyst would be sufficient to spark a market rally.
Market round-up
Despite the prevailing bearish sentiment up and down Wall Street, the first quarter of the year (Q1) surpassed expectations with robust global economic growth and improved business sentiment fuelled by consumer resilience and China’s reopening.
Banking turmoil, however, quickly got the bears growling about how the fastest hiking cycle in decades was inevitably going to cause a new financial crisis as bond markets priced in a recession, with many pointing to US commercial real estate as the next shoe to drop. The negativity was, however, overdone. Indeed, it was proven that 2023 is nothing like 2008.
Market sentiment rebounded, fuelling a continued rally and increasing optimism as Q2 approached. Despite concerns about the lagged effects of rate hikes and tightened credit in the US, the global economy showed resilience, with the rest of the world poised to counterbalance any potential slowdown.
Recent developments debunked this rotational shift theory as China’s reopening underperformed and Europe entered a technical recession in Q4. In contrast, the US has shown resilience compared to its peers at this advanced stage of the hiking cycle.
Market performance
The first half of the year (H1) was kinder to balanced portfolios, delivering around a 7% return (2022: -13.6%). Developed market equities performed well (Q2: 7%, H1: 15%), helped by growth and inflation surprises.
In Q1, European stocks slightly outperformed US stocks, supported by positive flows into the region (7.8% vs 7.4%). However, in Q2, US stocks staged a significant comeback led by Big Tech companies (8.8% vs 2.5%), as the China reopening trade ground to a halt due to weak economic indicators despite government stimulus efforts. Lower earnings expectations and valuations entering 2023 resulted in strong performances for US (16.9%) and EU equities (10.49%) during H1.
Optimism grew as there were hopes of US inflation moderating without significant impacts on growth and unemployment. This led to the S&P 500 leading global equities into a new bull market, with a 20% increase from October’s lows by early June. Credit spreads narrowed and the investor fear gauge (VIX index) remained low.
Active and agile portfolio management is essential for capitalising on opportunities and adapting to evolving market dynamics
It is important to note that the rally in US stocks has primarily been driven by multiple expansion, while forward earnings estimates have declined. Mega-tech companies, driven by the excitement over machine learning and AI, played a significant role in shaping this market trend.
The ‘Magnificent 7’, including Apple (50%), the first three-trillion listed company, Nvidia (189%), Tesla (113%), Microsoft (43%), Amazon (55%), Alphabet (36%) and Meta (135%) delivered impressive returns of +60% in 2023 (2022: -40%). Despite their recent gains, both the Magnificent 7 (-5%) and the broader market (-8%) have not fully recovered from losses since the start of 2022.
Mega-cap tech in the US has been the pain trade for investors, but funds are no longer underweight. The AI gold rush boosted tech valuations, with multiples rebounding to 34x, reasonably below all-time highs of 41x. Semiconductor companies, vital for AI’s computational power, make for the proverbial shovel, gaining 46.3% in H1. This valuation re-rating fuelled the rise of the S&P 500, while generative AI could drive further earnings growth while tech’s cash reserves lend valuation support.
Navigating the new reality
The market’s sharp turnaround and heightened macro volatility highlight a new era of increased market volatility. Divergent asset class performance underscores the importance of portfolio diversification.
Commodities, last year’s top performer, faced challenges this year (Q2: -3%, H1: -8%), with notable declines in oil (-11.9%) and gas (-37.5%). Global government bonds posted modest gains of 1%, while high-yield credit and Italian government bonds stood out with around 5% returns in fixed income.
Performance divergence was evident globally across asset classes, geography, equity size and style, sectors and stocks. Equities decoupled from the credit market significantly outperforming high-yield (15% vs 5%); developed markets comfortably outperformed emerging markets; large-cap growth outperformed small-cap value (27.5% vs 3.4%); and technology outperformed energy (39.4% vs -3.2%). Market-weighted global indices also outperformed equally weighted indices (15.4% vs 9%).
Navigating this new reality requires granular analysis, selective sector and company decisions, and identifying shorter-term opportunities. Active and agile portfolio management is essential for capitalising on opportunities and adapting to evolving market dynamics.
Looking forward
The market debate has shifted from hard landing to crash landing, soft landing and even no landing over the year. The global economy is softening but not collapsing, inflation is declining slowly and Western hiking cycles are nearing their end, albeit some of the impacts are yet to play out.
These unexpected deviations in H1 have deeply divided Wall Street strategists on H2. Distinguishing pandemic-related disruptions from normal late-cycle patterns and the underperformance of leading indicators to hard data have complicated the assessment of economic trends.
Major asset managers are split on the outlook: short-term optimism but growing pessimism on high-yield bonds and stocks. Long-duration government debt is preferred. As we enter the slower summer season, market focus turns to fundamentals as earnings estimates decline for non-AI beneficiaries.
Despite high valuations and a concentrated equity rally, a significant Q3 pullback is unlikely due to the resilience of US equities to higher rates. Labour market dynamics keep the market tight, but profit margins may face pressure without further loosening. Upcoming Q2 earnings will shed light on company performance in this context.
Q3 is expected to bring market consolidation, with stocks and bonds trading within a range. Market pricing of recession risk and signs of a credit cycle emphasise the importance of balanced equity positioning and quality in bonds.
Josef Luke Azzopardi is a portfolio manager at BOV Asset Management Ltd.
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