Despite a notably steep “wall of worry” that included ongoing banking system strains, persistent inflationary pressures, the most aggressive Federal Reserve (Fed) tightening campaign in four decades, elevated valuations across most major risky asset sectors, and unresolved geopolitical headwinds—e.g., Russia-Ukraine war, slumping Chinese economy, euro area at/near recession—performance across the financial markets in the second quarter appeared overwhelmingly positive. Domestic asset classes and sectors generally witnessed more robust performance during the quarter than their international brethren, reflecting the U.S. economy’s relative resilience amid incrementally tighter monetary conditions and souring global economic momentum. Incoming U.S. economic data over the quarter continued to surprise to the upside, however, which suggests the Fed’s efforts at tamping inflation and engineering a modest amount of demand destruction are only partially complete.
Significant performance gains were experienced within the mega-cap technology sector in the second quarter despite the space’s embedded interest rate sensitivity. Small and microcap equities also posted positive performance but lagged their larger cap counterparts meaningfully. International developed and emerging market equities underperformed domestic equity indices for the second quarter, with fundamental challenges coming into focus— particularly in China and across the euro area. Bond returns were mixed, with higher quality and rate-sensitive sectors lagging the shorter duration and credit-oriented sectors as rates saw a material increase and credit spreads tightened. Real asset performance was similarly mixed, with a seemingly deflating global economic engine serving as a headwind to commodity prices and real estate and global listed infrastructure sectors posting essentially flat performance.
At their mid-June policy meeting, the Fed maintained the 5.25% targeted upper bound on the federal funds rate, a decision that market participants had largely priced in throughout the weeks that preceded the announcement. Through updates to their Summary of Economic Projections (SEP)—including a refreshed “dot plot” overview of where committee members expect the appropriate rate of the policy rate should stand in the coming quarters— the Fed opened the door for future rate hikes. Notably, Chairman Jerome Powell described the July 25-26 meeting as “live” numerous times during the post-announcement press conference.
After more than a year of tightening monetary conditions, which included ongoing quantitative tightening and a 500-basis-point increase to the policy rate to date, the Fed appears close to declaring “mission accomplished.” Supporting this potential shift in the trajectory of monetary accommodation is a significant deceleration in the rate-of-change of inflation; while still elevated versus the Fed’s 2% desired level, both core and, more so, headline inflation rates have trended lower in recent months.
Annual headline consumer price inflation, for example, reached a cyclical peak of 9.1% in June 2022 but deflated to a more modest 4.0% pace through May 2023. Core inflation has followed a similar downward path, albeit at a more measured decelerating pace. Central to the disinflationary pressures that have surfaced in recent months are global supply chain bottlenecks which have largely been worked off. In fact, the New York Federal Reserve’s gauge of global supply chain pressures reflects the greatest spare capacity among global supply chains since the end of the Global Financial Crisis, a trend that may help dampen further inflationary gains.
The flip side of the decelerating path of inflation is the U.S. economy’s pronounced resiliency. Despite the most aggressive Fed tightening campaign in over 40 years and percolating economic weakness abroad, incoming U.S. economic data has predominantly surprised to the upside since March. Indeed, the Bloomberg U.S. Economic Surprise Index spent the second quarter trending higher, lending some credence to the “soft landing” narrative— one which had seemed a near impossibility during the brief banking system crisis this past spring.
It would be premature to declare smooth sailing for the U.S. economy as growth rates across leading economic indicators continue to suggest a downturn is likely in the coming quarters. Moreover, the labor market, while strong in absolute terms, has exhibited few signs of further improvement/tightening; the slope of the Treasury yield curve remains deeply inverted; the manufacturing sector—a historically reliable harbinger of swings in the business cycle—has appeared stuck in contraction for nearly the past eight months; and sticky inflation, while on a clear downward trajectory, remains stubbornly elevated and at risk of reaccelerating should the Fed fail at fully restoring price stability given the historically tight labor situation.
To conclude, the second quarter of 2023 presented global investors with outsized performance gains across many widely followed asset classes and categories, particularly in the U.S., where investors embraced the renewed potential for an economic soft landing amid relatively strong incoming economic data and cooling inflation, a scenario seemingly off the table just a few months ago. Relatedly, the risk-on sentiment that permeated the investment community during the quarter served to underpin a meaningful increase in many commonly referenced valuation measures, which, when paired with stubborn fundamental headwinds, continues to demand a cautious approach when flexing risk budgets over the near-term.
INDICES
The Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships that provides investors with an unbiased, comprehensive benchmark for this emerging asset class.
Bloomberg Fixed Income Indices is an index family comprised of the Bloomberg US Aggregate Index, Government/Corporate Bond Index, Mortgage-Backed Securities Index, and Asset-Backed Securities Index, Municipal Index, High-Yield Index, Commodity Index and others designed to represent the broad fixed income markets and sectors. On August 24, 2016, Bloomberg acquired these long-standing assets from Barclays Bank PLC. and on August 24, 2021, they were rebranded as the Bloomberg Fixed Income Indices. See https://www.bloomberg.com/markets/rates-bonds/bloomberg-fixed-income-indices for more information.
The CBOE Volatility Index (VIX) is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500 Index option bid/ask quotes. The Index uses nearby and second nearby options with at least eight days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.
FTSE Real Estate Indices (NAREIT Index and EPRA/NAREIT Index) includes only those companies that meet minimum size, liquidity and free float criteria as set forth by FTSE and is meant as a broad representation of publicly traded real estate securities. Relevant real estate activities are defined as the ownership, disposure, and development of income-producing real estate. See https://www.ftserussell.com/index/category/real-estate for more information.
HFRI Monthly Indices (HFRI) are equally weighted performance indexes, compiled by Hedge Fund Research Inc. (HFX), and are used by numerous hedge fund managers as a benchmark for their own hedge funds. The HFRI are broken down into 37 different categories by strategy, including the HFRI Fund Weighted Composite, which accounts for over 2,000 funds listed on the internal HFR Database. The HFRI Fund of Funds Composite Index is an equal weighted, net of fee, index composed of approximately 800 fund- of- funds which report to HFR. See www.hedgefundresearch.com for more information on index construction.
J.P. Morgan’s Global Index Research group produces proprietary index products that track emerging markets, government debt, and corporate debt asset classes. Some of these indices include the JPMorgan Emerging Market Bond Plus Index, JPMorgan Emerging Market Local Plus Index, JPMorgan Global Bond Non-U.S. Index and JPMorgan Global Bond Non-U.S. Index. See www.jpmorgan.com for more information.
Merrill Lynch high yield indices measure the performance of securities that pay interest in cash and have a credit rating of below investment grade. Merrill Lynch uses a composite of Fitch Ratings, Moody’s and Standard and Poor’s credit ratings in selecting bonds for these indices. These ratings measure the risk that the bond issuer will fail to pay interest or to repay principal in full. See www.ml.com for more information.
Morgan Stanley Capital International – MSCI is a series of indices constructed by Morgan Stanley to help institutional investors benchmark their returns. There are a wide range of indices created by Morgan Stanley covering a multitude of developed and emerging economies and economic sectors. See www.morganstanley.com for more information.
The FTSE Nareit All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs.
Russell Investments rank U.S. common stocks from largest to smallest market capitalization at each annual reconstitution period (May 31). The primary Russell Indices are defined as follows: 1) the top 3,000 stocks become the Russell 3000 Index, 2) the largest 1,000 stocks become the Russell 1000 Index, 3) the smallest 800 stocks in the Russell 1000 Index become the Russell Midcap index, 4) the next 2,000 stocks become the Russell 2000 Index, 5) the smallest 1,000 in the Russell 2000 Index plus the next smallest 1,000 comprise the Russell Microcap Index, and 6) U.S. Equity REITs comprise the FTSE Nareit All Equity REIT Index. See www.russell.com for more information.
S&P 500 Index consists of 500 stocks chosen for market size, liquidity and industry group representation, among other factors by the S&P Index Committee, which is a team of analysts and economists at Standard and Poor’s. The S&P 500 is a market-value weighted index, which means each stock’s weight in the index is proportionate to its market value and is designed to be a leading indicator of U.S. equities, and meant to reflect the risk/return characteristics of the large cap universe. See www.standardandpoors.com for more information.
Information on any indices mentioned can be obtained either through your advisor or by written request to information@feg.com.
DISCLOSURES
This report was prepared by FEG (also known as Fund Evaluation Group, LLC), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directly to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202, Attention: Compliance Department.
The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. FEG, its affiliates, directors, officers, employees, employee benefit programs and client accounts may have a long position in any securities of issuers discussed in this report.
Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.
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Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that the investment will achieve any particular rate of return over any particular time period or that investors will not incur losses.
Past performance is not indicative of future results.
Investments in private funds are speculative, involve a high degree of risk, and are designed for sophisticated investors.
All data is as of June 30, 2023 unless otherwise noted.