July 20, 2023
Despite concerns of additional financial instability after regional bank failures in the US, stubbornly high inflation globally, geopolitical concerns over Russia and Ukraine, and strained relations between the US and China, both domestic and international markets moved higher in the second quarter. Global market sentiment, however, shifted during this period to a more hawkish stance – from expectations for an end to the rate hiking cycle towards global tightening that may take longer to play out. Most major economies are slowing and at risk from aggressive central bank tightening and while headline inflation is falling in many countries, the stickier services inflation pressure is forcing central banks to continue their tightening campaigns. Global yield curves remain inverted as markets price in additional rate hikes along with concerns of a policy mistake.
Indeed, most major central banks raised rates during this period. Given the increased risk of a policy error and the concentration and contribution of a handful of overbought names driving market cap weighted indices higher, we continue to favor diversification and have continued to move more neutral in our asset allocation (equity to fixed income, value to growth style, and US to international) policy.
Concerns over downward estimate revisions and tightening credit conditions continued to weigh on more economically sensitive value exposures. Due to heightened recession risk, we sought out greater balance within our style allocations by reducing some value oriented positions and increasing exposure to domestic and international growth. We maintained our small cap allocation given the compelling relative valuation profile, which began to pay off as the market showed signs of broadening out in the last month of the quarter – we expect market breadth to continue to improve throughout the year. We modestly reduced defensive exposures but maintained the health care position given its compelling valuation profile and defensive characteristics.
China allocations continue to struggle as concerns over sustainability of the economic recovery surfaced. However, we anticipate continued rate cuts and various other stimulus measures announced by the Chinese government to aid economic recovery and youth unemployment. Expectations for economic growth remain in the 4-5% range, a metric we are watching closely. Emerging Markets, which lagged developed markets during the quarter, remain attractive from a relative valuation perspective. We anticipate strong earnings growth next year, and additional stimulus from China to jump start their economy should benefit this exposure. Although energy prices remained range bound in the second quarter, our energy exposure detracted from performance. Improved global demand, with support from an improving Chinese economy, and announced production cuts should see better performance here going forward, as we saw in June.
In the fixed income markets, rates moved up over the course of the quarter. The 10 Year Treasury yield moved from a low of 3.3% on April 5 to 3.8% at the end of the quarter. We added additional funds to bonds, modestly increasing our duration as yields moved higher.
The widely anticipated recession in the US continues to be pushed out, possibly into 2024. We continue to expect a significant slowing in both economic and corporate profit growth in the US, although we believe many international markets and profit growth could look stronger, in addition to their attractive valuation profile relative to domestic markets. Inflation should slow broadly as commodity prices decline in the face of easing demand, providing some relief to central bank policy. We remain comfortable in our reduced exposure to equities and believe that the fixed income portfolio will not only increase diversification, but also benefit from a modestly longer duration. We continue to wait patiently for further evidence of investor capitulation on the economic and earnings outlook for this coming year. As economic and earnings recession forecasts become reality, a more compelling risk/return opportunity for the strategy should develop. We stand ready to deploy our buying reserves as that happens.