July 2023 Market Commentary

August 17, 2023

The saying “Hope springs eternal” traces its roots back nearly 300 hundred years to “An Essay on Man: Epistle I” by Alexander Pope, published in 1733. What was true then, remains so now as evidenced in July by investors’ growing optimism that the Fed might in fact achieve an elusive soft landing. For more than a year, Wall Street and Main Street have fretted about an impending recession. Depending upon the source, the recession was (is) expected to range from mild to severe and was expected to begin anywhere from imminently to the next 6-12 months. The thinking was that the Fed’s aggressive rate hikes, meant to combat the highest inflation in 40 years, would lead to a sharp slowdown in economic activity, a corresponding spike in unemployment, and ultimately a recession.

Thus far, however, a recession has failed to materialize. Now, with the Fed nearing the end of its rate hike cycle, labor markets remaining healthy, consumer spending positive, and other measures of economic activity improving, investors are becoming increasingly optimistic that the Fed may in fact buck historical precedent and manage to subdue inflation without triggering a recession. Against this backdrop, equity markets enjoyed positive returns in July with large caps (S&P 500) gaining 3.1%, while more economically sensitive small caps (Russell 2000) rose 6.1%. International markets also recorded positive returns with developed markets (MSCI EAFE) gaining 3.2%, while emerging markets (MSCI EM) gained 5.8%, their best month since January.

A notable feature of this year’s equity market performance has been its narrow “breadth.” Breadth refers to the ratio between advancing and declining stocks within an index or market. In 2023, the S&P 500’s gains have been led by a relatively small number of tech and tech-related stocks. Through the end of July, though the index was up 19.5% for the year, 159 stocks (32%) within the index had a negative return, while 358 (72%) had a return less than the index. Excluding the tech sector, the S&P 500 was up still up a respectable 12.2% but trailed the full index by over a third. Conversely, the S&P 500 tech sector was up 46%, while an even more concentrated index of tech and tech- related stocks, the NYSE FANG+ Index, was up 81%.

With year-over-year S&P 500 earnings growth negative in both the first and second quarter, most of this year’s equity market returns have been driven by multiple expansion, i.e., investors being willing to pay more for the same $1 of earnings now than they were at the beginning of the year. That has pushed the S&P 500’s price-to-earnings (P/E) ratio back above its 15-year average. Given the elevated valuations and ongoing, though waning, concerns about the possibility of a recession, markets may struggle to maintain their first half momentum without a widening of breadth in the second half.

In another sign of the growing optimism surrounding the US economy, Fed Chair Jay Powell noted after the Fed’s July meeting that the central bank’s staff economists no longer expect a recession in 2023. Instead, they now anticipate a “noticeable” slowdown in growth starting later this year. Mirroring those comments, the current Bloomberg consensus forecast shows GDP growth slowing to 0.5% in 3Q, down from 2.4% in 2Q, and then contracting slightly in 4Q, before reaccelerating in 2024.

An area of particular interest for investors in the months ahead will be the health of labor markets. Despite the Fed raising rates by a cumulative 5.25% since March 2022, and their stated expectations for softer labor market conditions, thus far that has generally failed to materialize. Since the start of the year, non-farm payrolls have added an average of 258K new jobs per month. Over the past two months, however, the pace has slowed, with new job creation in June and July registering at 185K and 187K, respectively. With the economy likely not having fully felt the cumulative effect of the Fed’s rate hikes, labor conditions could weaken further. A meaningful downshift in hiring from current levels or even net job losses would undoubtedly lead to renewed fears of recession.

Unlike equity markets, bond market returns were effectively flat in July, with the Bloomberg US Aggregate Bond index, the broadest measure of the US bond market, edging down 0.1%. Performance was hampered by rising yields which recovered to levels last seen just prior to the banking turmoil in March. In the immediate aftermath of the failures of Silicon Valley Bank and Signature Bank, yields cratered on expectations that the Fed would start cutting rates immediately to avoid a steep economic downturn, at one point pricing in four rate cuts before year end. Instead, despite a more cautious tone, the Fed pressed forward with three additional rate hikes over its next four meetings. Even with the additional failure of First Republic Bank at the end of April, market expectations have slowly recovered and now expect the Fed to hold rates steady until March 2024. Based on the Fed’s most recent forecast released in June, and comments by Fed Chair Jay Powell following the Fed’s July meeting, another rate hike, perhaps at the Fed’s next meeting in September, is not out of the question.

In response to incoming economic data, yields fluctuated over the course of July, rising early on, then retreating, before moving higher again to end the month. At the long end of the Treasury yield curve, the 10-Year and 30-Year yields rose 0.12% and 0.15%, to 3.96% and 4.01%, respectively, benefitting from positive employment, GDP, and consumer confidence data. That strength was central to the improved investor optimism regarding the likelihood of a soft landing. At the short end of the curve, the 2-Year Treasury yield saw less volatility, as the market has consistently projected a likely end to Fed rate hikes following the July meeting. Incoming data prior to the Fed’s September meeting will play a pivotal role in determining whether officials pursue additional rate hikes.

The municipal market saw a similar pattern to Treasuries, with positive economic data pushing yields higher. Though the pattern was similar, the municipal market was much less volatile, with the 2-year AAA Muni rising just 0.01% and the 10-year AAA muni falling 0.02% overall on the month. Municipal issuance has been light throughout 2023, helping to support higher municipal prices. Issuers, flush with high tax receipts and Covid-19 relief aid, have largely delayed any new deals in anticipation of a lower rate environment ahead. The lack of supply has helped municipal bonds outperform the Treasury market.

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Information and research contained herein do not represent a recommendation of investment advice to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment, and it does not constitute an offer or solicitation to buy or sell any securities. It is not possible to invest directly in an index. There is no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. Past performance is not a guarantee of future results. These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. The views and opinions expressed in this publication are subject to change, at any time, without advance notice or warning.