Market Outlook

June 30, 2023

During the second quarter of 2023, the US economic outlook remained fairly balanced. Some indicators, including the labor market, consumer spending, and the housing market, remained quite strong. Others, including the Leading Economic Index (LEI), the Manufacturing PMI, and the stubbornly still-inverted yield curve, point to an impending recession. First quarter earnings were better than anticipated, and the fallout from Silicon Valley Bank ended up being more a whimper than a bang. Pundits have been forecasting a recession for many months now, but neither current economists’ GDP forecasts nor analysts’ earnings forecasts reflect a recession in the next 18 months. A recession may still come – a slowdown certainly appears to be coming – but at present, its arrival keeps getting pushed farther into the future, if it comes at all.

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Macroeconomic: Steady as She Goes

During the second quarter of 2023, the US economic outlook remained fairly balanced. Some indicators, including the labor market, consumer spending, and the housing market, remained quite strong. Others, including the Leading Economic Index (LEI), the Manufacturing PMI, and the stubbornly still-inverted yield curve, point to an impending recession. First quarter earnings were better than anticipated, and the fallout from Silicon Valley Bank ended up being more a whimper than a bang. Pundits have been forecasting a recession for many months now, but neither current economists’ GDP forecasts nor analysts’ earnings forecasts reflect a recession in the next 18 months. A recession may still come – a slowdown certainly appears to be coming – but at present, its arrival keeps getting pushed farther into the future, if it comes at all.

Inflation, which has been the driving force of the last 18 months, is abating. Headline inflation has decreased to 4% and is still declining. Core inflation is proving to be somewhat stickier and may remain above the Federal Reserve (Fed) target of 2% for some time. Higher interest rates have been a global phenomenon, as central banks around the world raised interest rates to fight inflation.

The US equity market was very narrow in the first half of 2023, with just a handful of companies accounting for the lion’s share of returns. Our analysis suggests that companies outside those very largest ones are quite attractively valued. This includes smaller US companies as well as international developed market companies. We expect equity market leadership to broaden over the coming quarters.

Higher-for-longer interest rate expectations from the Fed have led to higher fixed income yields across the asset class and across the yield curve. Interestingly, lower quality credits have performed better than higher quality credits. This implicitly reflects a rosy economic outlook; in a poor economy, these lower-quality credits would be at risk of default. Instead, investors have bid up their prices.

In response to these changes in the environment, we made several changes to client asset allocation in the quarter. We reduced exposure to floating-rate bank debt as the Silicon Valley Bank episode highlighted the risks facing some bank issuers. Where suitable, we also initiated an allocation to an asset-backed lending strategy, a form of private credit. As banks continue to tighten lending standards due to higher capital requirements, less money is available for lending, leading more companies to borrow from alternative funding sources such as private credit. Finally, we increased exposure to developed market equities. These have been valued more cheaply than US equities for years; the catalyst we see now for some of that gap to close is the stronger relative earnings growth of companies outside the US.

As we look to the rest of 2023 and into 2024, we expect continued crosscurrents in the economy; we expect equity performance to broaden beyond merely the seven largest companies; we expect interest rates to stay higher for longer, making shorter-duration fixed income more attractive; and we expect private credit to continue to take market share from traditional bank lending. Economic reacceleration may materialize in 2024, which could drive economic and market indicators to normalize to a more typical early-cycle dynamic. We will continue to carefully evaluate new information as it becomes available and keep our eyes firmly on the long-term opportunities for our clients.


Fixed Income Update

It was another resilient quarter for the US economy, and many recession forecasts have been walked back or pushed out to 2024. Economic data has mostly exceeded low expectations but has been mixed. Housing, measures of consumer and business spending, and US job market data have been durable, while manufacturing indicators reflect recessionary conditions. The cumulative effect of the Fed’s interest rate hikes has been tighter credit conditions, but inflation remains sticky and persistent. US Core Personal Consumption Expenditures (PCE), one of the Fed’s preferred inflation gauges, has now been above its 2% target for 29 consecutive months.

The Fed has been observing economic data and inflationary pressures, and the weight of the evidence suggests that monetary policy needs to be tighter. Currently, interest rate markets are forecasting that one or two more 0.25% rate hikes will be needed in the second half of 2023. The current expectation is a sharp divergence from March, when the market expected upcoming interest rate cuts, in response to the collapse of Silicon Valley Bank and Signature Bank. After ten straight meetings with a rate increase, The Federal Open Market Committee (FOMC) chose to “skip” an interest rate hike at June’s meeting, but with the implication that future rate hikes are forthcoming.

A stable economy and a reassessment of monetary policy drove the movement in interest rates during the quarter. The most notable move was in the 2-Year Treasury yield, which increased by 0.87% to 4.89% and is nearing its high from early March. The 10-Year Treasury also increased by 0.37% to 3.84% in the quarter. This movement in interest rates means the yield spread between the 2-Year Treasury and 10-Year Treasury is at -1.07% (-107 basis points), which is the most inverted that the yield curve has been since 1980. As we have discussed in previous newsletters, an inverted yield curve occurs when long-term yields are lower than short-term yields, and this can be an ominous sign for the economy. The negative effects of an inverted yield curve often materialize through a lagged reduction in credit availability, which can cause the economy to contract. Economic implications could be upcoming, but the Treasury curve has been inverted for over a year now, without any major fallout. After years of low rates and fiscal stimulus, which allowed consumers to build savings, the economy is clearly more resilient than many expected. Just like the economic fallout that never materialized after the bank failures in March, the implications of an inverted yield are not always as inevitable as they may seem.

This year’s risk-on rally in equity markets has also been reflected in corporate credit spreads and High Yield sector returns. The Bloomberg US Corporate High Yield Index started the year yielding +4.58% (458 basis points) to a comparable US Treasury and has since tightened all the way to +3.87% (387 basis points). A level of +3.87% is the lowest that the spread has been in the last year and is just below the index’s 5-year median of +3.89%. This spread tightening has led the index to a +5.38% return year-to-date. This number is even more impressive when you consider that CCC-rated bonds, the lowest credit quality cohort, led those returns. CCC-rated bonds have returned an impressive +9.35% year-to-date. Tighter corporate spreads and strong CCC-rated bond returns reflect the market’s optimism about the US economy and the robust credit health of corporate issuers. We do not currently have an allocation to the High Yield asset class but plan to add one when an attractive opportunity materializes.

In other fixed income sectors, municipal bonds are still a great investment for those seeking tax-exempt income and limited volatility. Here we favor highly rated issuers of General Obligation bonds and revenue bonds backed by essential service cash flows. Treasury Inflation Protected Securities (TIPS) still look attractive to us if inflation remains persistent. Inflation breakeven spreads are forecasting that inflation will average only 2.22% over the next five years. If inflation exceeds those expectations, TIPS have the potential to outperform. Finally, our expectation for market volatility means an allocation to high quality, liquid US Treasuries is prudent.

As we move into the second half of the 2023, the US economy is likely to remain resistant to recessionary pressures. Unfortunately, this means inflation will be tough to tame and the Federal Reserve will have to maintain its tight monetary policy stance. After a decade where the mantra was that rates would be “lower for longer”, we may be entering into a new environment of “higher for longer” as it pertains to interest rates. Without the tailwind of ultra-low rates, risk assets are going to have to perform on their own merits and likely with increased volatility. On the positive side, we expect that fixed income securities will continue to offer attractive yields, improved diversification benefits, and be a meaningful contributor to portfolio returns in the years ahead.


Sustainable Investing: Natural Capital – Broadening Beyond Climate

In the annual World Economic Forum (WEF) Global Risks Report released earlier this year, biodiversity loss and ecosystem collapse ranked 4th in severity on the top-10 risks over a 10-year period, behind only climate-related risks. Economists, investors, regulators, and other stakeholder groups are all increasingly focusing on natural capital and biodiversity as the next frontier in sustainability analysis.  As major global reporting frameworks and regional regulations develop, both risks and opportunities are emerging for corporations and investors.

To start, it is important to define terms. Natural capital refers to the world’s stocks of natural assets, covering soil, minerals, water, air, and all living things, so in total, a stock of natural ecosystems.  Biodiversity is the variety and variability of all living things, a fundamental component of natural capital, essentially a measure of diversity at the genetic, species, and ecosystem levels. Biodiversity plays a critical role in ensuring the resilience of other natural capital assets. Ecosystem services are the flows of benefits derived from natural capital, including a wide array of benefits underpinning human civilization, including clean air, crop pollination, climate regulation, among many others. Our natural world is a vast array of interconnected and symbiotic ecosystems that support human life on this planet.

A recent OECD report sized the total value of ecosystem services at $135 trillion, or roughly 1.5x global GDP at the time of the estimate.  A joint paper from WEF and PwC in 2020 assessed the materiality of nature loss on business, showing that $44 trillion of economic value generation, or 50% of global GDP is moderately or highly dependent on natural capital and ecosystem services. As noted in the OECD report, economic growth has been exponential over the last 50 years, lifting more than 1 billion people out of poverty, and advancements in health, technology, and other areas have been astounding. While advancements have been remarkable, our standard measurements of success do not account for the costs to nature.

As McKinsey & Company notes in a recent report titled Nature in the Balance, we are using resources and drawing on natural capital as if we had 1.8 earths. McKinsey uses the concept of planetary boundaries to frame their research, with one important finding showing that human activity is extending beyond the safe space for four of the seven boundaries with reliable data. Biodiversity loss, chemical and plastic pollution, nutrient pollution, and greenhouse gas emissions are all well beyond the safe zone, while forest cover loss and freshwater consumption are in the zone of uncertainty. The bottom line is that natural capital is in decline. Declines in biodiversity, as illustrated in the chart below, and many other indicators of natural capital loss are clear signals that human activity is putting significant pressure on nature.

The title of this article refers to an expanding corporate and investor view of the environment beyond climate change. It’s important to note that natural capital and particularly biodiversity are inextricably interconnected with climate change.  Climate change is a major driver of habitat loss through extreme weather, shifting weather patterns, and other impacts, while biodiversity loss through deforestation reduces natural carbon sinks and contributes to shifting rainfall patterns. While clearly linked, natural capital and biodiversity measurement and analysis is significantly more complex than climate change.

Natural capital does not have just one metric like greenhouse gas emissions, and impacts are generally local, not global in scope.  Additionally, reporting and data are at the early stages of development, making investor assessments of systemic risk or multi-dimensional risk to corporations challenging.

Thankfully, governments are finally committing to address nature loss, and frameworks and regulations are emerging that will affect both corporations and investors. The UN Biodiversity Conference (COP 15) in December 2022 resulted in a landmark agreement by over 190 countries covering pledges to conserve at least 30% of land, inland water, and sea by 2030. While many governments have now committed to action, in the background a group of corporations and investors have pushed forward a risk management and reporting framework called the Taskforce on Nature-related Financial Disclosure (TNFD). The fourth and final draft TNFD framework was released in March and final recommendations are expected in September 2023.

As TNFD emerges, swift uptake is expected as the framework is modeled on the well-understood Task Force on Climate-related Financial Disclosures (TCFD), a framework widely used by corporations to report climate risks. The TNFD goes a step further by covering impacts on nature along with corporate risk and opportunity. The goal, as with TCFD, is to bring some standardization to reporting that will enable more decision-useful information for investors and other financial service market participants.

As the TNFD and regulations in Europe, such as the Corporate Sustainability Reporting Directive, lead to more transparency, robust data, and targets for improvement, investors will need to come up the curve on integration and reporting. While reporting and integration of natural capital risks, opportunities, and impacts are still early stage, the spark has been lit and action is finally coming.

The Living Planet Index (LPI) is a measure of the state of the world’s biological diversity based on population trends of vertebrate species from terrestrial, freshwater, and marine habitats.  Globally, monitored populations of birds, mammals, fish, reptiles, and amphibians have declined in abundance by 69 percent, on average, between 1970 and 2018. In other words, the average change in population size in the LPI is a decline of 69 percent. This does not mean that 69 percent of the species or populations are declining nor that 69 percent of populations or individual animals have been lost.


Equity Market Outlook: Object in Mirror Are Closer than They Appear

The large capitalization US equity market continued a remarkable rebound in the second quarter of 2023. The S&P 500 index posted an 8.7% total return in the quarter, which brings the total return since the closing low last fall to a whopping 25.9%. The S&P 500 now lies just 4.9% below the record high reached last January despite a wide array of geopolitical and economic challenges that have arisen in the interim. Given the scale of the recovery in share prices, many investors today may be tempted to shrug off the 2022 experience as it fades in the rear-view mirror. Our approach has been more cautious as economic and financial market data remain mixed, although unambiguously better than we anticipated at the beginning of the year. As a result, we urge investors to avoid watching the rear-view mirror and stay focused on the road ahead, which remains rife with both risk and opportunity.

The defining characteristic of the US stock market in 2023 has been narrow market leadership. The index has become unusually concentrated in a handful of large growth companies that have thrived in recent years, and these shares have posted spectacular results over the past 6 months. For example, in the first half of the year, the return contribution from the five largest companies in the S&P 500 was an incredible 15.0%, which represents 89% of the index’s 16.9% overall gain. This is the highest relative return contribution from the five largest companies in at least 40 years. These companies (Apple, Microsoft, Amazon, Nvidia and Alphabet) have benefitted as risk appetites have returned because they seem likely to be the prime beneficiaries of investment in artificial intelligence and cloud computing. However, they also represent a risk for the broader market given their scale and valuation.

After a brief respite following the correction of 2022, valuations of large growth companies have returned to elevated levels. The chart below compares the price-to-estimated earnings ratio for the S&P 500 capitalization-weighted index (in blue) with and an equally weighted mix of the same 500 stocks (in red) over the past 15 years. The dotted lines represent the median valuation during this time period. The excessive valuations of the stimulus-fueled pandemic era returned to normal last year, but the S&P 500 has subsequently risen to a meaningful premium over the historical median while the equal-weighted version of the index has not. Although the timing is difficult to predict, the valuation gap as shown in the chart is clearly unusual and we expect it to narrow over time – likely through a combination of lower valuations of large companies and improving relative earnings growth from the rest of the index.

Large growth companies have gained appeal not only because of their exposure to exciting growth opportunities like artificial intelligence, but also because of their ability to grow in an environment of slowing economic activity. The S&P 500 is currently mired in an “earnings recession” where overall earnings are declining (expected to drop by 3% this year but reaccelerate to 11% earnings growth in 2024). It is notoriously difficult for the market to consistently post gains while earnings are declining, so an end to this dynamic as markets shift their focus toward 2024 could prove to be the catalyst for broader participation in this nascent bull market.

Despite the recovery in the stock market, the risk of economic recession is still elevated as highlighted by the inverted yield curve and declining LEIs. In the event of an economic recession, the drop in earnings could prove more severe in both duration and magnitude than currently estimated, although we would expect some additional warnings from credit and labor markets confirming broader economic trouble if this were to happen. In the meantime, earnings of the equal-weighted S&P 500 is expected to outpace the S&P 500 with 5% earnings growth this year and an acceleration to 11% growth next year. The most likely scenario in our view is that companies outside of the large cap growth names gain relative appeal over recent leaders during the course of the next year or two unless derailed by a more protracted economic downturn.

The bottom line is that incoming economic and financial market data have been conflicting and uncertainty remains high. From a long-term perspective, equity valuations are enticing outside of a handful of stocks that appear overvalued. Until we see more evidence of a significant economic downturn, we are targeting a fully invested position in equities with a bias towards high quality companies that are likely to thrive throughout the economic cycle. Of particular interest as we go forward are areas within global equity markets such as international companies or smaller US companies whose valuations appear to have some catching up to do. Most importantly, this seems like a particularly hazardous time to be driving while looking in the rear-view mirror. Financial markets are diverging in unusual ways that present both new risks and opportunities. In this environment we believe investors would be well-advised to focus on the road ahead by maintaining a diversified and disciplined long-term investment approach.


Alternatives: Private Equity

In recent years, the size and scope of the private credit markets has grown to the point where it has become its own distinct asset class. While the asset class is young if evaluated by the availability of institutional and retail investment products to access these credits, the industry itself has existed within the US for decades. Prior to the Global Financial Crisis (GFC), most lending businesses existed within banks and a select number of large non-bank lenders. The private credit universe was limited to either sub-scale or highly complex situations that couldn’t be financed by traditional lenders. In the wake of the GFC, tighter regulation due to Dodd-Frank required banks to improve their capital ratios and reporting. This caused them to narrow their lending to the largest and most liquid assets. As banks withdrew, the private credit industry stepped in to fill the void of providing capital to smaller businesses, consumers and niche areas of the market. As the capital has flowed to the private credit market, so too have the talented and experienced individuals that previously ran these businesses within banks.

The private credit market has grown to an estimated $1.5 trillion and the avenues for growth remain robust. While banks have focused on the largest relationships, most of which are public companies, the number of private companies of substantial size has increased. In the US, there are more than 30,000 private companies with revenue between $50 million and $500 million. These are not large enough for the publicly traded equity and debt markets but are very meaningful for the universe of non-bank lenders. Within that universe of private companies, there are an estimated 10,000 private equity-owned businesses, a nearly 5-fold increase over the last 20 years. In addition, the private debt markets have witnessed an increasing volume of large – over $1 billion – issuances, as large borrowers have chosen the speed and surety of execution in the private markets over the potential volatility and uncertainty of public market syndications.

While lending to private equity-backed businesses attracts most of the private credit headlines, the private credit market is broader and covers a wide variety of asset types and collateral profiles. Notable segments of the market include cash flow direct lending (corporate lending), asset-based lending (e.g., real estate, equipment), consumer lending, venture lending, distressed lending, and niche market lending (e.g., litigation, royalties). Typically, all parts of this broad universe are floating rate (no interest rate risk), have bilaterally negotiated credit terms and covenants, and have dedicated teams that are focused on extracting alpha (excess returns) through their credit selection. While some market segments are more competitive than others, effectively eroding alpha potential, managers have historically demonstrated positive alpha: they have exhibited lower default rates and higher recoveries upon default than both the broad markets and bank lending portfolios. This is further demonstrated by the returns for private credit, which have meaningfully outperformed comparable public loan and high yield indices.

As the private credit industry emerged post GFC, the offerings were primarily closed-end and institutional in nature. This means that the funds were limited to Qualified Purchasers, had high minimums, drew down capital over several years, distributed income and principal over several years, and tax reported through K-1s. Industry product innovations have allowed the asset class to become available to high net worth investors through evergreen Limited Partnerships, and to retail investors through Interval Funds and non-traded Business Development Companies (BDCs). The benefits of the retail products are that they are registered fund offerings, are available to Accredited Investors at lower minimums, have streamlined subscription and custody profiles, and provide 1099 rather than K-1 tax reporting. With these innovations, retail investors are now able to gain access to best ideas investments on equal footing with institutional investors with respect to managers, asset/liability structure and the prudent use of term-matched leverage.

We have recently expanded and broadened the role of private credit within our tactical asset allocation framework. As the economic outlook continues to remain highly uncertain, we view this as a valuable tool in the toolkit for maximizing risk-adjusted returns going forward, and for insulating portfolios from interest rate volatility while monetizing credit selection alpha. We have chosen to emphasize asset-backed lending strategies, which is where the lender has the most direct collateral protection from business assets (e.g., real estate, critical equipment) and where the opportunity set has improved dramatically with the ongoing retrenchment of small and regional banks this year.