Plum Street Advisors
2023 Q2 Commentary
During the second quarter of 2023, the market continued its rebound from 2022’s declines. The foundations of the economy continued to stabilize as price and interest rate increases leveled off, while at the same time investor enthusiasm about artificial intelligence (AI) went through the roof.
A mini-mania around AI and the generative AI chatbot ChatGPT erupted this year as enthusiasm on Wall Street built about the potential for the new technology in a wide variety of industries. Nvidia, up 190% year to date, makes computer chips that are central to the huge computing power needed for AI. Microsoft, which has significant investments in the company that built ChatGPT, is up 43% so far this year.
At Plum Street Advisors, we are not stock pickers, and we will refrain from commenting on whether Nvidia is or isn’t worth over 200 times trailing earnings. Generally speaking, however, history suggests that the impact of new technologies on future company earnings is often overestimated. Competition comes in, and the simple extrapolation of short-term growth to the long term doesn’t hold up. This has been true from the South Sea Company crash of 1720 to Cisco’s crash after the internet bubble of 2000. Similar to Nvidia’s role in the emerging AI field today, Cisco was rightly considered a core supplier for the future of the internet some 25 years ago. It was a good company, with excellent growth and margins, but it was wildly overvalued amid enthusiasm over the potential of an emerging new technology. As the dot-com bubble deflated, Cisco stock lost 80% of its value in the two years following its March 2020 high.
Apart from the AI craze, which has been concentrated among US growth stocks, the rest of the markets have continued to post steady improvement as fears of inflation and rising rates are abating. The looming recession, which has been imminently expected for well over a year now, still seems to be a ways off, as first quarter real GDP growth was recently raised to 2.0 percent by the Bureau of Economic Analysis. It would seem reasonable to expect that when the next recession does arrive, it may be more muted than was initially anticipated.
The Russell 1000 index of large US companies gained 8.6% in the second quarter of 2023. Growth stocks, led by technology, continued to outperform value stocks this year as they rebound from their downturn in 2022. The Russell 1000 Growth gained 12.8%, while the Russell 1000 Value index gained 4.1%. For the year, the Russell 1000 Growth index is up 29% so far (compared to a loss of -29% in that index in 2022).
Smaller companies generally trailed their larger counterparts. Concern about rising rates has weighed most heavily on smaller firms which in some cases will find it harder to meet the higher cost of borrowing. The Russell 2000 was up 5.2% for the quarter – with more growth-oriented names outperforming more value-oriented names.
International stock gains were more modest, with MSCI EAFE, the developed market index, posting a total return of 3.0%. Japan was an outlier, gaining 15.0% in the quarter and rising 23.2% for the year so far. The MSCI Emerging Markets index was up just 0.9%. China lagged other countries with a -9.7% decline, as their post-COVID recovery sputtered.
The Federal Reserve took a pause on raising rates in June, but US Treasury bonds still sold off toward the end of the second quarter as the Federal Reserve signaled more rate hikes would likely be needed this year. Inflation continued to slow, however, which should help keep a lid on excessive rate speculation in the longer maturities.
For savers, higher rates will end up being a good thing, despite the decline of bond values that rising rates caused in 2022. Earning a reasonable, above inflation return on bonds will help diversified portfolios support retirement income for many in the years to come.
A diversified mix of bonds may help reduce bond volatility, as recent experience has shown. The Bloomberg Aggregate Bond index declined -0.8% for the quarter while foreign bonds did better, as the Bloomberg Aggregate ex-USD Hedged index gained 0.7%.
Currencies and Commodities
The US dollar ended the second quarter mixed, gaining against the yen and the Chinese yuan, but weakening compared to the Euro and UK sterling. Oil and copper prices ended the quarter sharply lower, weighted down by slower-than-expected economic progress in China. Gold reversed earlier gains as inflation concerns and safe-haven demand abated. Gold fell -3.1% for the quarter, despite still being up for the year.
We continue to look at bank stability as a key concern as we look ahead to the rest of 2023. Following the failure of Silicon Valley Bank and Signature Bank in the first quarter, First Republic Bank was closed in the second quarter.
The good news for banks overall is that deposit outflows have abated. For the month of June, total deposits in US banks increased slightly. Also, the largest US banks remain strong and resilient, according to a stress test conducted by the Federal Reserve. The largest 23 banks in the country all met minimum capital requirements in a severe stress test which simulated a global recession with a 40% decline in commercial real estate prices, 10% unemployment, and commensurate declines in economic output.
The bad news for banks is that interest rates continue to increase, hurting the value of bank bond investments. The 10-year Treasury Note traded back above 4% on July 6th, which is similar to the levels reached in early March during the earlier bank crisis. Commercial loans will likely be a problem area for regional and smaller banks as rates continue to rise and building values fall. We’ll be monitoring this risk closely this year.
More broadly speaking, the US economy continues to surprise to the upside. The long expected and widely touted recession has been held at bay for now. The economy continued to grow, inflation has declined to 4.0% as of the latest CPI reading, and the job market remains robust. Let’s hope the Federal Reserve is able to balance its interest in pushing inflation down even further with also maintaining the health of banks and the overall economy.