Welcome to the second half of 2023. The first half ended with a bang as stocks rose again Friday to bring first half gains for the S&P 500 to almost 16%. That was the best first half performance since 2019. If you look at the components at the top of the average, you can understand why. Apple#, Microsoft#, Alphabet#, Amazon#, Tesla, and Nvidia# all rose by at least a third. In each case, the stocks rose faster than forward earnings projections. That put forward P/Es up to 22 or more for each.
Valuations stretch when investors expect an acceleration in growth beyond previous expectations. Perhaps prospects for artificial intelligence applications raised outlooks. It certainly did for some, although I’m not sure why people are going to buy more iPhones in order to write a term paper on a ChatGPT platform. In any case, for such performance to replicate in the second half of the year, either prospects must advance further, there must be upside in second half earnings performance, or speculative fever must accelerate. At the moment, of the three, rise in speculation would be the most obvious.
While the S&P was rising almost 16%, the Dow rose 4%, more indicative of the pace of economic activity. Thus, it would seem the speculative fever within the market was relatively contained. Big tech wasn’t the only first half winning group. There were winners within the travel and leisure segment, some specialty retailers and other growth names. Losers were most prevalent in regional banks (for obvious reasons), REITs, utilities, and energy. In short, gainers and losers reflected economic circumstances as well as the impact of higher interest rates.
So, what lies ahead? Inflation is receding but at a pace insufficient to satisfy the Fed. The most important inflation component, shelter costs, should recede in the second half, reflecting the slowdown in rents. But higher interest rates will keep “imputed rents” high. Oil prices spiked well over $100 per barrel when the Ukraine war broke out but have steadily receded to about $70. Normally, oil prices peak around Memorial Day and bottom near Thanksgiving on a seasonal basis. A slower economy, a move toward alternative fuel sources and an increase in electric car sales should weigh on demand. However, supply growth is also falling. I am not going to predict oil prices but see no reason, near term, for any surge in price. If there is to be a second half surprise, it would probably be to the downside.
With all that said, Fed Chair Jerome Powell has all but committed to a July rate increase. There will be an employment report Friday and an inflation report next week that could change that, but both would have to be well beyond the current range of expectations for that to happen. Mr. Powell talks of further increases ahead but Fed predictions beyond the next meeting have proven to be too inaccurate to count on. Let’s simply say that as long as Core CPI or PCE growth year-over-year is over 4%, the likelihood is that the Fed will keep increasing rates. But in any case, it is near the end of a cycle. Short term rates could rise as much as another percentage point at the extreme. That’s a far cry from the five-percentage point increase since March 2022. As for long rates, they reflect longer term inflation expectations. They have been well anchored for months. Thus, the fluctuation in yields at the long end of the curve has been well contained. Yields on 10-year Treasuries, currently around 3.85% could move a half a percentage point in either direction. But again, that shouldn’t weigh heavily on stock prices.
Stock prices are a function of both earnings and interest rates. Interest rates should be less impactful on stock prices in the second half of the year than the first half. What about earnings? So far this year, they have been relatively flat. Economically sensitive segments (e.g., retailing or manufacturing) may feel some second half pressure. But the consumer hasn’t shown signs that they are slowing spending at all, at least not yet. Savings rates are down, and consumer debt is up. That suggests a more reluctant consumer going forward. Last week, the Supreme Court shot down Biden’s student loan forgiveness program. Interest starts accruing again in September and loan repayments are due to restart in October. It is too early to know whether the Biden administration will have alternatives to lessen the pain, but 40+ million Americans are destined to have to divert some money toward student debt later this year. That won’t help as Christmas approaches.
Thus, it seems unlikely that the second half of 2023 will replicate the first half. That doesn’t mean stock prices have to go down. In fact, when the S&P has risen at a double-digit rate, the odds strongly suggest further gains in the second half. The one notable exception was 1987 when stocks rose sharply into August at the same time bond prices were falling. That led to a sharp valuation correction in the fall. While there are similarities between 1987 and today, history never exactly repeats itself, but it can often rhyme.
With the outlook somewhat foggy, here are some factors to watch that will impact second half performance.
1. Number one has to be the path of inflation. Many predict a sharp fall in the second half, but we have heard that for months and the deceleration has been slow. Unemployment is still well below 4% and wage pressures will recede slowly.
2. Will the consumer continue to spend as vigorously as in the first half? There are no signs yet, but for reasons stated above, it would seem the excess savings accumulated during the pandemic could run out fairly soon.
3. AI. For months we have heard the hype. During the second half, we will see more evidence as to how the surge in interest related to generative artificial intelligence translates into real use.
4. Ukraine. The most likely outcome is continued stalemate. The ball would seem to be in Russia’s court. No one is predicting a fast Russian victory. Cracks have appeared in Putin’s leadership, but it is too early to jump to any conclusions. Normally war isn’t bad for stocks and the war in Ukraine has had only a modest effect so far. But there are outlier possibilities that could be impactful.
5. China. Economically, China is far more important than Ukraine. Growth is decelerating and tensions between China and the U.S. remain high. While attempts are being made to ease tensions, Taiwan remains a flash point. The Ukraine war demonstrates Western resolve that should make Xi reticent to be overly aggressive.
6. The FTC. Chair Lina Khan doesn’t like business. More accurately, she doesn’t trust big business to behave. She opposes a high percentage of large company mergers or takeovers. So far, courts have stopped much of what she has tried, but fighting the Commission in court takes time and money. Might a series of defeats cool Khan’s ardor?
7. Politics. All signs point to a Trump/Biden rematch. More than two-thirds of America doesn’t want to see that. Progressives love Biden. The MAGA Republicans love Trump. There remains about 40% in the middle unhappy with both. The resolution is a 2024 event, however. Unless something significant happens to alter the course, politics should not matter much to the rest of this year.
8. Momentum. We all can see that momentum is the friend of equity investors now. Yet stocks are not overbought on a technical basis and the VIX volatility index is very low. Momentum doesn’t change easily. That’s why market tops don’t happen in the same way as market bottoms. Right now, there isn’t a hint of slowing momentum, but one should be watchful.
In conclusion, the current path of least resistance is higher, but the odds favor a decelerating economy and more earnings pressure. History, including stock market performance in the third year of a presidential term, suggest a good second half, but not nearly as good as the first half. The best sign would be a broadening of leadership, something absent from the first half of 2023.
Today, Audra McDonald is 53. Tom Cruise is 61. Playwright Tom Stoppard, who just won a Tony Award, turns 86.
James M. Meyer, CFA
610-260-2220