Quarterly Review and Outlook – 2nd Quarter 2023
The first half was full of surprises and contradictions. The economy kept chugging along despite rate hikes. Inflation fell quickly despite continued labor market strength. Housing prices bottomed despite nosebleed mortgage rates. Stocks rallied sharply despite bank failures and a weaker earnings outlook.
Financial analysts construct models using decades of data from the economy and markets. No model is perfect, but good ones are often useful for cutting through the noise. Even the best models have struggled in recent years, though, because this cycle was started by a virus and not the typical excess of a market economy. This simple fact colors every data point. Policymakers responded to an invisible enemy with overwhelming force and things got weird. No buildings were destroyed. Our productive capacity was not impaired. Instead, consumer behavior changed overnight, and our fantastically complex economy needed time to adjust.
In January, we wrote that investors should embrace the uncertainty and use all of the tools available to them, since nearly every asset class was priced for attractive returns over the next several years. We still liked the technology sector, but it was not the only game in town.
A diversified portfolio has performed well. Our differentiated view on credit has been accretive, and our lean toward value, dividends, and small caps produced solid returns. On the other hand, technology was still the best performing sector, fueled in part by excitement around Artificial Intelligence (AI).
Calling this a bubble is premature. The largest technology stocks have indeed risen sharply this year, but it is important to keep in mind that last year was truly miserable for the sector. Since peaking on 12/27/21, the S&P 500 is down about 5%, the Nasdaq about 7%. Most other areas—value, small caps, international—have outperformed over this period. The peak-to-trough decline for the Nasdaq was over 30%, more than twice that of a low-volatility dividend-focused strategy.
For now, the math supporting earnings growth is enough to justify owning a broad portfolio of stocks over a multi-year time horizon. Nominal growth is strong, inflation is falling, and domestic industrial investment is booming due to the CHIPS and Inflation Reduction Act. The challenge to a concentrated technology portfolio comes from valuation. It may be hard to get strong earnings growth from here without also getting higher real rates and even tighter monetary policy.
Outside of those names, valuation and rates are less of a concern. Quality, dividend-paying companies are not nearly as expensive and should hold up relatively well in a downturn. Small caps have lagged for some time, in part due to the large population of unprofitable, highly leveraged businesses that comprise the index. We think a strategy that separates the wheat from the chaff can benefit from a cyclical uplift in earnings and the end of the Fed hiking cycle.
Outside of equities, fixed income plays a valuable role in nearly all portfolios. The yield on high quality short-term bonds is in excess of 5% and, given persistent strength in the economy, warrants an overweight position. We also like higher yielding corporate bonds that we believe offer equity-like total returns with more downside protection. Credit spreads are only around their long-term average, but the combination of rate plus spread is unusually high and provides a natural hedge.
In private markets, lending opportunities are compelling. The pullback from banks and other poorly-capitalized participants has provided experienced lenders a huge amount of pricing and negotiating power. They can choose the best assets with the best sponsors. They can originate loans with lower Loan-to-Value (LTV) ratios, better interest coverage, higher yields, and lender-friendly covenants.
A good portfolio is resilient to change. Last year was shock therapy for stocks and bonds. It was not a particularly fun ride, but diversification and prudent risk management cushioned the journey. Now we see a more friendly investment landscape—higher returns available in more places. The world is moving fast, and we reserve the right to change our minds as we are presented with new surprises and contradictions.
Please reach out with any questions or comments.
|Clay McDaniel, CFA
Chief Investment Officer
|John B. Cox, CFA, CAIA
Chief Investment Officer
Disclosure: Past performance may not be indicative of future results. The opinions expressed in this commentary reflect information available at the time it was written and should be used as a reference only. Due to various factors, including changing market conditions, economic conditions, and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Waverly. If you have any questions regarding the applicability of any specific issue discussed above to your individual situation, you are encouraged to consult with your Waverly adviser or the professional advisor of your choosing. A copy of Waverly’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or by visiting https://waverly-advisors.com/ADV-Part-2A-Brochure. Please see additional important disclosures on the last page of this report.