Improving Inflation and Better-Than-Expected Earnings Help Q2 Markets Overcome Challenging Financial Landscape

Posted by Jeffrey Buchbinder, CFA, Chief Equity Strategist

Wednesday, June 5, 2023

Index Performance

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Equities Cap Off Strong First Half with Solid Second Quarter Gains

The S&P 500 continued its strong 2023, returning 8.7% including dividends in the second quarter to bring its first-half gain to 16.9%, its best since 2019. The Dow Jones Industrial Average posted a quarterly gain of 4%, but the big winner was the Nasdaq Composite, which gained 13.1% during the quarter as growth outpaced value on significant gains in mega-cap technology stocks. The Nasdaq’s more than 32% first-half gain was its best since 1983.

Price pressures have steadily declined, with the consumer inflation rate down to 4% on an annual basis as of May 2023, compared with 8.6% a year ago. Given the improvement with the inflation landscape, some market participants believe prices will continue to decline and the Federal Reserve (Fed) could still produce a soft-landing.

Corporate resilience surprised Wall Street during first quarter earnings season as corporate America faced several headwinds. Still-high inflation and related cost pressures, along with stress in the banking system that caused financial conditions to tighten after the bank failures in March were among analysts’ concerns heading into first quarter reporting season in April. Actual earnings came in about five percentage points better than expected, helping markets push forward during the second quarter.

Even with an improving price outlook and better-than-anticipated earnings, the global economic landscape remains challenging. In addition, the Fed and other major global central banks remain hawkish, with ‘more work to do’ in their fights against inflation, increasing the risks of an eventual recession.

Large Caps and the Growth Style Outperformed on Mega-Cap Technology Strength

Large and small cap stocks delivered gains during the second quarter; however, large caps continued their outperformance on the back of strong performance from the consumer discretionary and technology sectors. During the quarter, the large cap dominated Russell 1000 Index returned 8.6%, compared to 5.2% for the small cap Russell 2000 Index. Year to date, large caps have more than doubled up their small cap counterparts, 16.7% to 8.1%.

Even as small cap valuations appear attractive and provide less exposure to international economic risks, they are more susceptible to domestic economic challenges and financial stress, evidenced by their notable underperformance following the banking turmoil in March.

Growth-style stocks far outpaced their value counterparts during the second quarter, as the Russell 1000 Growth Index returned 12.8%, compared to the 4.1% return for the Russell 1000 Value Index. Even as growth outperformed during the second quarter, the gap was smaller than in the first quarter as some investors took advantage of attractive valuations and the possibility of an economic soft-landing. As during the first quarter of this year, growth received a boost from its overweights in the information technology and consumer discretionary sectors during the second quarter. Growth-leaning technology topped all sectors for the quarter.

The first half outperformance by large growth, 29% to 5.1%, was the second largest gap since 1979, the largest coming in the first half of 2020. The top eight stocks in the Russell 1000 Growth Index drove 75% of the first half gain.

LPL Research favors large cap stocks for the second half due to elevated recession risk and maintains a neutral style stance, for now, as valuations favor value but falling inflation and the potential for lower interest rates may help growth stocks stay afloat.

International Equities Struggled to Keep Up with the U.S.

The U.S. took back the regional leadership baton from international markets as the MSCI EAFE Index returned 2.3% during the second quarter, well behind the S&P 500’s nearly 9% gain. Emerging markets (EM) fared worse, as the MSCI EM Index was only able to manage a 1% gain, though EM saw significant dispersion. China lost nearly 10%, while Latin America gained 14.3% powered by a 20.8% surge in Brazil. During the first half, the S&P 500’s nearly 17% gain far outpaced that of international (+11.7%) and EM (+4.9%).

Simply put, the outsized gains for mega-cap U.S. growth stocks made it difficult for developed international equity markets to keep up, especially with Germany mired in a technical recession. Still, Japan’s 6.3% second quarter gain in U.S. dollars was quite respectable as its economy continues to hold up relatively well amid continued accommodative monetary policy. A budding trend toward more shareholder friendly corporate practices and recent breakouts to multi-decade highs for some of Japan’s most widely-followed market indexes have also increased interest in Japanese equities, which LPL Research believes have become attractive recently as a relative play in a slowing global economy.

Strong Quarter for Credit as Higher Interest Rates Pressure Core Bonds

Core bonds, as defined by the Bloomberg U.S. Aggregate Index, lost ground during the quarter as central bank hawkishness pushed rates higher. The 0.8% decline for the index in the second quarter brought its first-half gain down to 2.1%.

Global central banks remain steadfast in curbing price pressures, even as inflation declines. The most credit-sensitive sectors of the bond market, including bank loans, corporate high-yield bonds, and preferred securities, outperformed during the second quarter, while the most interest rate sensitive sectors lagged, most notably U.S. Treasuries.

High yield credit outperformed during the quarter despite tightening bank lending standards following the regional bank stress in March. The fundamental backdrop for corporate borrowers is starting to deteriorate as the global economy slows. Given our expectations of a slowing economy, LPL Research doesn’t think valuations in general are compelling to invest in the riskier fixed income markets, with the exception of preferred securities where valuations continue to look attractive in the aftermath of the regional bank stresses.

Commodities Struggle as Inflation Improves

The Bloomberg Commodity Index gave back an additional 2.6% this quarter after losing ground during the first quarter, leaving the index down 7.8% during the first half. Signs of cooling inflation in the U.S., slowing global growth, warmer weather reducing seasonal heating demand, and declining crude oil prices were among the reasons commodities sold off during the quarter.

The case for commodities as an inflation hedge is less compelling with inflation likely to continue its steady decline in the months ahead. LPL Research prefers precious metals as a hedge against geopolitical risk and as a way to position for a potentially weaker U.S. dollar.


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