Q2 2023 Income and Growth Commentary
by Robert Cagliola, CFA and Robert Hahn, CFA, on July 26, 2023
“The reports of my death are greatly exaggerated” is a famous quote attributed to Mark Twain following inaccurate rumors of his death. After a 7.5% bounce in Q1, many investors expected the death of the market rally or a market pullback at a minimum, given numerous headwinds, including the debt ceiling, the collapse of Silicon Valley Bank, and concerns of a recession in the second half of the year. Instead of declining, the S&P 500® Index rose 8.3% in Q2 as the market climbed the proverbial wall of worry. The debt ceiling crisis was avoided following an agreement in Washington, D.C. and positive results from the Federal Reserve’s (“Fed’s”) stress tests helped restore confidence in our financial system and enabled banks to increase dividends and stock buybacks. Most importantly, the inflation rate continues to decline, coming in at 4% year-over-year in May as measured by the Consumer Price Index (CPI). This compared to 4.9% in April and allowed the long-awaited pause in the Fed’s interest rate hike program. The economy has remained resilient despite a 500 basis point (5%) hike in rates over the past year. The labor market remains strong, with non-farm payrolls beating expectations for 15 consecutive months. During the second quarter, Technology extended its outperformance for the year, with the sector up 16.9%. Consumer Discretionary and Communication Services were the next strongest performing sectors, up 14.3% and 12.8%, respectively with much of the gains driven by mega-cap names such as META +35%, AAPL +17.6, AMZN +26.1% and MSFT +18.1%. Underperforming sectors included Utilities -3.3%,and Energy-1.8%. We point out that there was some broadening of the market rally later in the quarter, with Industrials and Materials up 11.2% and 10.8% in June, respectlively. Despite the positive economic data points, inflation remains well above the Federal Reserve’s 2% target rate. Commentary from the Federal Reserve suggests up to two additional 25 basis point (0.25%) interest rate hikes before year-end, creating the potential for some near-term retracement. Stock performance in the third quarter will likely depend on upcoming CPI numbers showing a further moderation in inflation. While markets could see a near-term pullback, we expect further (market) upside if/when the Fed completes its rate hiking cycle.
Portfolio Equity Positioning
We continued to position the portfolio to a more neutral posture versus the S&P 500® Index during the quarter, adding to quality secular growth and cyclical names found within lightly weighted sectors such as Consumer Discretionary and Financial Services. New purchases include Morgan Stanley (MS), Zoetis (ZTS), Stanley Black & Decker, and Lowes (LOW). We also added to Adobe (ADBE) and Abbott (ABT) positions. We used the strong rally in Technology to trim positions in NVIDIA (NVDA), Oracle (ORCL), Palo Alto Networks (PANW), and Cisco (CSCO). Positions sold included Nike (NKE) – inventory concerns and decelerating direct-to-consumer sales, Lockheed Martin (LMT) – tougher compares given the debt ceiling agreement and Disney (DIS) – lack of profitability in streaming and disappointing movie studio box office numbers. At quarter end, the portfolio maintained the largest sector overweight exposures versus the S&P 500® Index in Health Care (16.2% portfolio weighting), Industrials (10.4%), and Consumer Staples (7.9%), while Consumer Discretionary (8.7%), Communication Services (6.8%) and Technology (27.2%) continued to have the largest sector underweight exposure.
We believe that the market in the near-term seems ripe for some retracement given the stock market’s significant appreciation in the first half and the potential for two additional interest rate hikes in upcoming Federal Reserve meetings. The direction from here is predicated on a further decline in inflation and more dovish monetary policies. That said, the economy is growing better than expected, with 2% GDP growth in Q1 and continuing strength in the labor market. Despite tighter lending standards and higher interest rates, the economy has chugged along in part due to infrastructure spending both by the government as well as reshoring which requires manufacturing and supply chain facilities and warehouses. Housing has also been another area of strength despite higher mortgage rates due to demographics and a lack of supply of starter homes as Millennials form new households. While we cannot predict near-term market movements, we maintain a balance of both secular growth and value exposure and look to add to positions on any pullbacks.
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