Q2 | 23

Second Quarter Newsletter 2023

As we enter the second half of 2023, sentiment from investors is bullish but remains confused on the outlook for the economy and financial assets. Most investors entered 2023 with a view of an upcoming U.S. recession and positioned toward companies that would benefit from China’s reopening. As the year unfolded, recession turned into resiliency, inflation rolled over and financial asset positioning reversed. Growth stocks (technology) flourished, cyclicals suffered, and interest rates went up, not down as one would expect in a recession.
The market knew that Covid payments had left the consumer flush. With 70% of the U.S. economy driven by the consumer, their impact was significant. Over the last 12 months, U.S. companies have added more jobs than any other one-year period in history. The 2-year U.S. Treasury bond yield hit its highest level since 2007 at 4.9% at the end of the quarter. For the first six months of the year, stock benchmarks find themselves in positive territory. The key drivers of consumer spending are income, wealth, credit, and confidence. Recent economic growth has been surprisingly robust. Wage growth is rising in a tight labour market. Recent wealth gains on homes have acted to offset tighter lending standards on credit cards and consumer loans. So far-so good for consumer spending. The market is now attempting to figure out when the consumer will run out of excess cash.
In the second quarter of 2023, in USD currency the S&P 500 rose 8.7% and the Canadian stock market climbed 1.1%. Leadership in Q2 centered around growth stocks (Technology, Consumer Discretionary, Communication Services) although cyclicals, such as Industrials and Financials had a nice bounce. In Q2, stocks outperformed bonds. Both Canadian and U.S. bonds posted small negative returns of -0.7% and -2.2% respectively. The Canadian dollar gained 2.1% to the U.S. dollar.
Year-to-date, stocks and bonds both had positive returns. The U.S. market outperformed Canada (S&P 500 +14.2% vs. TSX up 5.7% in Canadian dollars). The dispersion between the best and worst sectors was dramatic. Technology stocks have enjoyed their strongest half-year performance in more than 20 years. However, all of Technology’s relative outperformance has come from multiple expansion. In addition, the market breadth is very narrow, as the six largest Technology companies accounted for 100% of the sector’s relative outperformance. Energy and Utilities both fell 7%. Bonds rose in the low single digits.


Sooner or later, a slowdown or recession will occur. How financial assets react will depend on when it starts, how deep it will be and how long it will last. Markets assume we can avoid a recession in 2023 given the momentum of the economy and strong labour market. We expect gains in wage and salary income to moderate but remain strong enough to maintain a slow economic expansion. The average unemployment rate so far this year is 3.5%, the lowest since 1969.

While prospects for recession remain unclear, the downward trend of inflation is now well established. Since peaking at 9.1% last June, year-over-year CPI inflation has now fallen for 11 consecutive months and stood at 3% as of June. We expect CPI to decline below 3% and then move sideways for the rest of the year.

After 10 consecutive increases, the U.S. Federal Reserve paused their interest rate hikes at their last meeting but indicated they envision two more rate hikes are possible by year end. With inflation falling and the supply chain improving, it seems that the argument for further monetary tightening is the tight labour market. We believe it hardly seems worthwhile to risk sparking a banking crisis or triggering a recession to achieve their inflation goals faster. In other words, it is our opinion that the hiking cycle is almost over, however we will see higher-for-longer interest rates.

China’s reopening has underwhelmed. China’s exports peaked in 2017, and since then its economy has been weak despite a sharp currency decline. China CPI has had 5 consecutive months of decline, pointing to weak domestic demand. We believe the question is not whether stimulus is coming, but rather how large and material it will be.

We expect equity markets to remain volatile during and after earning season, as consumers and businesses are likely to cut back on spending in reaction to tighter credit conditions and recession worries. Bond yields continue to rise, creating competition with equity returns. There is a dis-equilibrium. How can equities continue to rise while interest rates keep going higher? Equity investors expect demand to remain resilient and see a multi-speed economy with different subsectors experiencing variable growth rates (a rolling recession). This will lead to an earnings recovery in 2024. On the other hand, the bond inverted yield curve continues to scream recession. Maybe we will experience a recession, but much later than expected and stocks may hit an all-time high by the time this happens. As the path is not entirely clear, we have not changed our view about being in a middle-ground for financial assets and portfolio quality remains our focus. What will make us more bullish? A path to earnings recovery in 2024, a path to the end of a rate cycle and better market breadth.