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If it’s officially summer vacation, then the world and its news stations didn’t get the memo. The second quarter recycled the same old geopolitical headlines, hyper-focused on a record setting IPO, and pontificated on the appointment of a new Federal Reserve chair, Kevin Warsh. Despite the media noise, the board of governors, including Warsh, has clearly indicated their priority of managing inflation over employment. Middle class wage growth was outpaced by price increases yet again, so there was no move to reduce rates. And yet, markets rebounded at a historic pace—a reminder that short-term volatility doesn’t necessarily translate to poor market performance.
The key drivers of equity market increases this year are (1) earnings and fundamental strength, and (2) breadth. The price of any asset increases for one of two reasons. Either investors pay a higher price for the same fundamentals, or the fundamentals improve such that investors own higher value assets. In Q2, earnings and fundamentals improved and broadened. Prices then rebounded from March lows, and companies outside of the oft reported “Magnificent 7” big tech companies surged ahead (more on this below). We’ve written over the years about the historically top heavy, large company focused U.S. market and the inevitable diminishing returns that result. This year, equity markets have once again demonstrated that diversification and a disciplined investment strategy deliver a consistent outcome for investors.
Consider these five key points as we enter the second half of the year:
Through the end of the second quarter, emerging markets and smaller companies lead the way, at least doubling other major indices.
After March’s pullback, the following two months were the 16th best since 1950. Time to sell? Only if your personal headlines say so. Consider the average one-year return following such a rebound has been 24% since 1950. Resist the lure of using your crystal ball to “outsmart” the market!
Broad record earnings drove the rebound, and investors in passive indices with large allocations to the “Magnificent Seven” experienced a not so magnificent six months. Companies, other than the ‘magnificent 7,’ are on track for 35.9% earnings growth, and returns showed it. Notably, earnings outside the U.S. are on track for 25.6% growth, year-over-year, despite geopolitical conflict.
Kevin Warsh entered his new role as Fed chair, as inflation remains elevated at 3.62%, and the board of governors split votes are reminiscent of the early 90s, after the 1980s inflation spike. Some say we’re a broken record on this topic, but I prefer ‘artistically weathered vinyl.” If inflation remains elevated and employment is generally steady, rates should not be expected to decrease. Furthermore, real wage growth (wages minus inflation) is negative again, meaning the middle class can afford less. If the great American middle class must be a priority, inflation must still be the priority.
The Iran War cease fire came and went, and we are reminded that the Strait of Hormuz may be a better deterrent than a nuclear weapon. I’ll point you to our April note analyzing GDP growth and petroleum consumption since 1970 (link here). As the conflict continues, economic resilience will be put to the test, though there is still time. The world prepared for this after the 1970s crisis.
Though fundamentals, such as manufacturing and service indices, corporate earnings, and GDP show strength, headwinds persist. Inflation and its impact on the middle class remains a core structural issue, and geopolitical conflict and its downstream impacts may quickly shift capital flows and investor sentiment. Rather than predict, we prepare with your plan and portfolio. As we’ve seen through cycles in recent years and beyond, the path to your success is rooted in the creation and execution of your plan without wavering based upon short-term noise. We emphasize probability– which decision will increase your probability of success? Last quarter just provided another reminder of the value of discipline and diversification.
Optimistically yours.
Sources: Ycharts.com, Dimensional.com, Fred.com, ATLFed GDPNow, Factset.com, Lord Abbett Midyear outlook, Schwab midyear outlook
Disclosures:
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. It is maintained by MSCI Inc., a provider of investment decision support tools; the EAFE acronym stands for Europe, Australasia and Far East.
The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices in 21 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
The Bloomberg Barclays US Aggregate Bond Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the US bond market.
The Russell 3000 Index is unmanaged index comprised of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.
The Russell 2000 measures the performance of small capitalization U.S. stocks. The Russell 2000 is a market-value-weighted index of the 2,000 smallest stocks in the broad-market Russell 3000 Index.
The Standard & Poor's 500 (S&P 500(r)) Index is a free-float weighted index that tracks the 500 most widely held stocks on the NYSE or NASDAQ and is representative of the stock market in general. It is a market value-weighted index with each stock's weight in the index proportionate to its market value.
The 'Magnificent Seven' refers to a group of seven prominent U.S. technology-related companies: Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), Amazon (AMZN), Nvidia (NVDA), Tesla (TSLA), and Meta Platforms (META).
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