Episode 6 – Market Overview: First Half of 2023

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Hello, everybody. Thank you for tuning in to Market Perspectives, a Mercer Advisors podcast where we provide a data-driven, common sense perspective on the economy, on markets, and on investing I’m your host, Don Calcagni, Chief Investment Officer at Mercer Advisors.

Today, I’m going to provide a first half recap, basically an overview of markets and the economy over the past six months. And ultimately, I want to identify several key lessons that I believe we as investors should take away from that experience over the past six months or so.

And the reality is, if we step back and actually look at what has been happening thematically over the past six months, it really has not been a pretty picture by any measure. Inflation has remained stubbornly high.

Coming into the year, it was around 6.5%. It’s come down to around 4, but is still much higher than the Fed would like. We’ve seen the Fed continue to raise interest rates in February, in March, and again in May.

They did not raise at the June meeting, but they did telegraph to the market that they expect to hike interest rates at least one to two more times between now and year end. So that’s certainly not a positive development in terms of interest rates.

We’ve also seen really poor earnings growth this year. In fact, earnings growth estimates for the second quarter are that earnings will decline by almost 7%. That’s from FactSet’s Insights, earnings insight that they put out every so many days. So earnings have been exceptionally poor.

We’ve also seen a regional banking crisis that started back in March. We saw the failures of several banks, Silicon Valley Bank, Signature Bank, First Republic Bank, even Credit Suisse, a major global banking institution, now no longer exists. That’s a big change.

We also saw, for the first time ever, the very real prospect of a default on US government debt. Congress, I think, literally took that up to within 24 to maybe 48 hours of the US Treasury defaulting on our debt. Thankfully, they ultimately cut a deal, but certainly not a positive development as far as markets were concerned over the past six months.

Additionally, if we look at some other data, the New York Fed has a recession probability model that shows a 70% plus probability of a recession sometime in the next 12 months. That’s certainly not a positive development.

We also saw China moving very aggressively over the past six months to “de-dollarize,” quote unquote, the world. They’re trying to replace the US dollar or at least diminish the US dollar’s importance in global trade with their own currency, the Chinese Yuan. So definitely not a positive development.

All of this has ultimately combined to lead to an abysmally low consumer confidence. It’s not quite at all time lows, but it’s relatively close if you look at the data over the past 50 years. We’re pretty close to all-time highs with the University of Michigan’s consumer confidence index.

So all of this is pretty negative news by any objective measure. It’s certainly not a rosy picture if we were to just look at the headlines and some of the data over the past six months.

Yet despite all of that, despite all the negative press, we still don’t have a recession. The US economy, by most measures, remains surprisingly strong. So still no recession, even though the New York Fed’s recession model is forecasting a recession. A very high probability of a recession. We don’t see that showing up in the data, at least not yet.

But again, despite all of that data, markets posted blockbuster positive returns during the first half of 2023. Let’s just consider some of the data for a moment. US stocks over the first six months of 2023 rose 16.2%.

Non-US developed stocks rose 11.7%.

Emerging market stocks rose 5%. US bonds are up between 2% and 2.5%

And despite China’s very aggressive attempts to de-dollarize the globe, the US dollar finished flat during the first half of 2023. Basically, no change in value. Ultimately over the first six months of the year.

Additionally, if we actually look at the US dollar since early 2020, it’s actually up about 7% in value. It’s up 30% in value over the past decade. And the reality remains today, the US dollar still accounts for about 60% of global reserves. It is the world’s preferred and most dominant global reserve currency. And over 90% of all global foreign exchange transactions still involve US dollars.

So despite all of the negative headlines over the past six months, we’ve actually seen really spectacular returns in stocks and bonds. And we’ve seen the US dollar still continue to retain its status as the world’s primary and most preferred reserve currency.

So what are the key lessons that we as investors can draw from this apparent dichotomy between headlines and the data and what’s happening in markets? Well, I think the first lesson is that trying to predict the future path of the economy and markets is painfully difficult.

In fact, anyone who has studied markets and the economy for any length of time will tell you that it’s virtually impossible to try to form an investment thesis based on anything that’s happening in the broader economy. And I know that’s painfully difficult, right?

We always like to think that we can connect, perhaps a recession with what’s happening in markets. The reality is there’s really no discernible predictive relationship between what’s happening in markets and what’s happening in the broader economy.

Let’s just look at commodities for a moment here. Commodities are often touted as a wonderful strategy, a wonderful asset class for hedging inflation.

Now, I think we would all agree that we’ve had really high inflation over the past 12 months, and indeed we have. It’s some of the highest inflation since the early 1980s.

And the reality remains, though, that commodities have fallen about 18% in value. The Bloomberg commodities index has declined over 18% since June of last year. Energy, despite the war in Ukraine, despite the sabotage of the Nord Stream gas pipeline last year, energy overall is down 49% over the past 12 months.

WTI crude oil down 42.5%. Natural gas, on which Europe is heavily fully reliant for which Russia was Europe’s primary supplier, natural gas is down a staggering 77% over the past 12 months. Like I said, despite the ongoing war in Ukraine and despite the sabotage of the Nord Stream pipeline.

You certainly could not have predicted this decline in energy prices. If we were to go back 12 months to June and July of last year, I don’t think anybody in their right mind would have predicted such a staggering decline in oil and natural gas prices, given everything that was happening in the world.

If we look at markets, what we’ve also seen is that leadership within financial markets has pivoted quite rapidly. Energy by far was the best performing sector in the S&P 500 in 2022. It was up well note of 50%. Indeed, it was the only positive sector in the S&P 500 last year.

The communications sector was the worst performing sector in 2022. A lot of these are technology oriented companies, obviously. But we’ve actually seen this relationship flip during the first six months of this year.

Energy is now the second worst performing sector in the S&P 500 year to date through June 30. It’s down 5.5%. So certainly not a huge decline. But that comes on the heels of a market that overall is up 16.2%.

Communications, again, last year, the worst performing sector last year is now the best performing sector thus far this year, and it’s up 36.2%. Coming into the year, no one predicted such a dramatic turnaround in those two sectors returns within the S&P 500.

So that’s the first lesson trying to predict what’s happening in markets, trying to predict what’s going to happen in the economy is arguably a fool’s errand and is impossible.

The second lesson is that markets respond to prices. And let’s just take a look at energy. High energy prices following Russia’s invasion of Ukraine, oil peaked at $123 and change per barrel on March 8, 2022. They peaked in early March of last year, 2022.

In response to that, producers increased production.

US producers specifically increased production to fill that gap. In fact, global producers today are now forecasted to produce more oil in 2023 than they did in 2022. At the moment, when we look at the data, oil supply now actually exceeds consumption. It exceeds demand.

And anytime you have a situation where supply exceeds demand, what do we think is going to happen. It’s going to push down prices. And indeed, just a couple of days ago, on June 30, 2023, oil closed at $70.64

a barrel. That is a significant decline from where it was in March of 2022.

So I think it’s important to keep that in mind when we look at what’s happening in the world, whether it be export controls on rare Earth minerals by China, whether it be the sabotage of the Nord Stream pipeline, whether it be sanctions against Russian oil producers, the reality is that markets will ultimately respond to prices.

Companies will innovate to find ways to bring more supply to market. And that’s actually what we’ve seen. Simple economics, economics 101.

The third lesson for us as investors is that markets are forward looking. So you may be thinking, Don, this doesn’t make sense. How is it that markets can be up so spectacularly this year, given all of that negative news that you just shared with us?

Like I said, earnings are down. We had a regional bank crisis. Interest rates have continued to rise. Inflation is still stubbornly high. How is it that US stocks can deliver 16.2% in positive returns? That just doesn’t add up.

Well, indeed it does add up because markets are forward looking. Right now the market is looking past the Fed’s rate hiking policies. The market knows that the Fed is closer to the end of its rate hiking policy than the beginning.

Despite telegraphing one to two more rate hikes, the takeaway is that the reality is only raising rates another quarter point or half point, candidly, is not that significant compared to the 500 basis points in interest rate hikes that we witnessed throughout 2022. So the market’s looking past all of this.

And specifically with respect to earnings, earnings are actually forecasted to grow by about 11% over the next 12 to 18 months. So while earnings currently are negative, markets are looking forward.

The value of every asset in the market, whether it be a stock or whether it be a bond, whether it be a piece of real estate, is always the present value of future earnings, future expected earnings.

That’s what markets are looking for as investors. That’s what we’re looking for is the future earnings that we’re going to earn on our companies. And when we look forward what we see is we are forecasting about an 11% increase in earnings for S&P 500 companies. So that’s the third lesson.

The final lesson, and this is the most actionable in our view, is that it makes the most sense for all of us as investors to remain globally diversified. Trying to time markets, trying to rotate in and out of sectors, trying to pick individual winners and losers, that’s really all a fool’s errand. Doing so only drives up fees in your account. It drives up your taxes and does absolutely nothing to help improve portfolio returns.

The best approach, in our view, is to invest in an institutional grade portfolio that is personalized to your unique needs, your unique goals and your unique circumstances. So what does that mean?

An institutional grade portfolio is one that is exceptionally well diversified. It’s one that is designed and managed using the absolute best that financial science has to offer. It incorporates the latest Nobel Prize winning academic research into portfolio construction.

It’s a portfolio that is low cost. It’s a portfolio that is tax efficient. The only returns that matter are the ones that we get to keep after we pay the tax, man.

An institutional grade portfolio is one that is professionally managed. It’s monitored in real time by a full-time investment team, and it’s one that’s invested with and alongside other leading institutional investors. Think of investing with, for example, the best in class managers that you can find.

But most importantly, an institutional grade portfolio is one that fully reflects and incorporates your family’s unique goals and circumstances. It’s one that reflects your personal tolerance for risk, your capacity to assume investment risk, and also takes into account your need to assume investment risk in order to achieve your family’s unique goals and objectives.

Well, that’s all for today. Thank you for listening, and should you have any questions, please feel free to reach out to your advisor here at Mercer advisors. I’m Don Calcagni, and we look forward to seeing you next time.

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