Fall Outlook 2023

Post Pandemic Economy

The 2023 second quarter earnings season wrapped up last week, with AI industry leader Nvidia posting significant sales growth to become the first chip manufacturer with a market value in excess of $1.0 trillion.  Nvidia’s quarterly sales grew to $13.0 billion.  Yes, this is a great company, but a market valuation of 20 times sales and 200 times earnings is unlikely to end well for long-term investors.  So goes the theme so far in 2023.  Apple also hit a new high in the quarter, on its third consecutive decline in quarterly sales.  Tech companies are having an outstanding year, but as we will show, much of it is in the context of recovery from the technology sector’s 2022 market sell-off.  Headlines touting the gains are creating an atmosphere of a classic fear of missing out reaction – “FOMO,” for acronym aficionados.  Below, we explore three major themes:

1. Are we missing out on the market?
2. Is the U.S. economy falling apart?
3. Are there still good investing opportunities?

Missing Out?

 The chart below illustrates what happened during the 2022 market decline and the technology sector’s recent recovery.

A few key observations:

1. We are using October 12, 2022, as a reference point because that is the date the S&P 500 hit its low point. While the market broadly sold off, growth stocks, led by technology, had larger losses.  Despite impressive gains in 2023, the S&P 500 and technology-heavy NASDAQ 100 still have negative returns relative to their January 1, 2022 valuations.
2. 2023 stock market gains are concentrated in large company stocks. Mid-cap and small-cap growth sectors are still about 23% and 29% below the January 1, 2022 levels, respectively.
3. More “defensive” sectors, such as healthcare, did not sell off as much in 2022. While the gains off of the lows are not as exciting, returns are still ahead of the NASDAQ over the last 20 months.
4. What is most frustrating to us is fixed income performance, as represented by AGG. Usually, this is the asset class used for stability in portfolios.  We have written extensively about fixed-income losses due to the rapid increase in interest rates.  Unlike stocks, bonds (at least the vast majority of bonds) will repay the principal.  We feel the returns from bonds will be attractive, both in terms of current income and price recovery as bonds mature.

We also want to address recovery math, as we do from time to time.  Apple was down 31% at its low point in 2022, meaning if you had $100,000 of Apple stock on January 1, 2022, it would have been worth $69,000 at its nadir.  A 31% gain from that point would only leave you with $89,700 of stock.  Therefore, Apple has to increase its value at least 45% from the low for your stock to return to its original value of $100,000.  As illustrated below, despite its incredible gain in 2023, as of August 28, 2023, Apple was only 2.5% higher than 20 months ago.

With S&P 500 returns pushing towards 20% in 2023, it is important to understand that 8 of the largest companies out of 500 have contributed almost all of the return so far in 2023, and most of that return was recovery from the sell-off in 2022:

This outperformance is highly unlikely to continue.  Broader participation of other companies is necessary for the stock market to continue to advance.  Fortunately, we do think there are opportunities for that to happen.

U.S. Economy

There is good news: inflation is declining, unemployment is low, corporate earnings have been better than expected (80% of companies exceeded estimated earnings in the last quarter), and economic growth has outpaced virtually all economic forecasts.  Cash balances are also relatively high.

Yet there are some notable risks, and we want to highlight a few of our concerns.  First, there is no question that government spending is contributing to economic growth.  But as the chart below shows, the government is spending too much relative to revenues.  The exploding deficit is not sustainable without future dire economic consequences.

Here is a general rule of thumb: deficits can only expand at a rate equal to or less than economic growth without becoming a problem.  Currently, economic growth is less than 3% of GDP, while deficits are projected to be 5% of GDP.

The following chart illustrates one consequence of spending, particularly in a period where stimulus is added to an already strong economy.  As interest rates rise to control inflation, the cost of financing the federal debt starts to take much larger chunks of federal spending.

Our deficit is at historic levels, rivaling the end of WW II.  In addition, we face significant shortfalls in Medicare, which will not be fully funded under current projections within 8 years, and Social Security within 11 years.

There are major looming financial hurdles.  The Trump tax cuts will expire at the end of 2025.  In the meantime, cash balances are high enough, and fiscal stimulus will likely support at least some market sectors.

Finally, the question remains whether a collapse in office real estate or consumer spending will trigger a recession.  The following chart shows a dramatic increase in household debt.  While in the aggregate, household balance sheets are in good shape, there is a substantial part of the population that is struggling.  Student loan payments will also restart in October, likely representing additional stress to those struggling to pay their bills.

We often discuss political risk in international investments, particularly in emerging markets.  The U.S. has its own growing political risk.  With the September 30 deadline for Congress to pass a budget fast approaching, the political rhetoric is already bordering on toxic.  A government shutdown would likely not be good for markets, and we expect more volatility as we near the deadline.  The outcome may trigger some portfolio adjustments.

A Look at Potential Opportunities

Broadly speaking, we feel there are opportunities for investing in U.S. companies within the industrial and infrastructure sectors.  Small and mid-cap stocks will benefit if the current market rally broadens, particularly in growth sectors, including technology.   The homebuilders sector is particularly interesting, as demand for new housing significantly outpaces existing homes supply.  As mentioned above, fixed-income investments continue to look attractive, particularly if we are at or near the end of the Federal Reserve’s interest rate increases.

International Markets

In August, recent U.S. dollar strength contributed to a decline in international developed markets (Europe and Japan).  However, despite economic weakness, the International Developed Market Index, as represented by the ETF EFA, is positive for the year.  We feel there may be opportunities to increase exposure for two reasons.  First, current stock valuations based on earnings are attractive versus U.S. stocks.  Second, while we do not believe the dollar is in danger of imminent replacement as the “global reserve currency” (as some prominent headlines were suggesting earlier this month), we expect the dollar to weaken at some point as the U.S. addresses its fiscal deficit.  For the time being, we are underweight in international securities.

Emerging Markets

For now, emerging markets do not look attractive.  Perhaps China represents the best global investment opportunity on a fundamental basis, with attractive stock valuations and a somewhat positive growth outlook.  But the political and economic risks are high, as China’s once-hot real estate sector is on the verge of collapsing.  The U.S. went through its own real estate market woes in 2008, triggering a global economic contraction.  The trade war is also having an effect, with exports from China falling 14.5% year over year in July and imports dropping 12.4%.  As the world’s second-largest economy, China’s weakness negatively impacts global growth.  However, political pressure on China is not letting up and may add to China’s domestic economic woes.  Hence, we maintain that emerging markets do not look attractive, with one exception.

While tariffs and trade policy are directly impacting Chinese trade and supply chains, trade has picked up with Latin America, particularly in Mexico, as companies relocate manufacturing operations.  Thus, Latin America represents an attractive investment opportunity.

We feel current investments are well-diversified and suited for the current economic climate.  We are maintaining a modest over-allocation to bonds.  Our fixed income allocation could change depending on how the markets respond to fiscal and Federal Reserve interest policies.

As always, please contact us if you have any questions or comments.