2nd Quarter 2023 Commentary

Equity markets have rebounded smartly this year. We’d love to blow the ‘all clear’; we’re sick of being worried, but we’re not sure. If you’ve read these notes before, you know we’re partial to storytelling; it helps us try to avoid being wrong-footed by the markets’ beguiling short-term antics. This latest story reads like an Arthurian legend: pandemic, death and chaos, extreme fiscal and monetary reaction, relief, the escape of the inflation monster, and the return of the humbled hero to defeat the dragon. But the final act is unwritten. Will the Fed cause a recession whilst slaying inflation? And this being somewhat Shakesperean, another plot twist has been introduced: generative artificial intelligence (AI) and The Magnificent Seven. (We didn’t coin the term.)

A short intro to The Magnificent Seven: Apple, Microsoft, Meta (formerly Facebook, but comically renamed), Alphabet (Google, also comically renamed), Tesla, Amazon, and Nvidia are widely regarded as direct beneficiaries of generative AI, or thought to be impervious to rate hike consequences, or both. The Seven have contributed most of the S&P 500’s 17% return year-to-date. The leader of the group is up an astonishing 190%, while the laggard has contributed “only” 36%. They are, in fact, the seven largest companies in the S&P 500, and they make up a staggering 28% of the index. It’s a doozy of a plot twist that may eventually warrant its own tale. 

But back to the story. Despite the Fed’s extreme efforts to weaken the economy, GDP grew a revised (up) 2% in the second quarter and job market readings remain robust. Inflation has come down, but not enough. In short, more rate hikes are likely. This means more stress on the banking system as deposits flee, and more risk of a destructive credit cycle developing, meaning entities that must refinance will find it more difficult to do so, or almost impossible. Three large banks have already failed. The longer the Fed holds rates higher, the more risk that the last act in the drama is a recession. We’re in an interlude.

Interlude or not, though, the show rolls on. In the second quarter, the S&P 500 rose nearly 9%, with the Seven skewing the returns significantly higher; the group was up on average 27% for the period. The S&P 500 equal-weight index rose 4% as the market broadened its advance a bit. That was a better result than the first quarter, but still woefully behind the Seven-dominated cap-weighted S&P 500. Small caps rose 5%, with a year-to-date increase of 8%. The economy is not currently in recession and earnings estimates stopped falling, so stocks bounced in relief. That, plus the Seven is what drove results in the quarter, but as we said in the beginning, the final act is not yet written.

What to do? As much as we want to move on to the next narrative, we’re preparing for rates to be higher for longer. There’s a persistent labor and housing shortage that’s making rate hikes less potent. Additionally, there are technical reasons to suspect rates won’t reverse dramatically, mostly having to do with massive fiscal deficits worldwide that will need to be financed. This was masked over the last few years by persistent Fed (global) bond purchases, but that has ended. This increased competition for global savings is an important wildcard. But before we get too negative, we remind ourselves that the S&P 500 has gone from 3300 to 4500 since the end of 2019, a nearly 40% return. So, during this whole 3.5-year multi-act drama, stocks have risen significantly. The secret? Clearly, government stimulus propped up parts of the economy, but it’s also true that the equity markets are dominated by highly profitable businesses capable of navigating difficult economic conditions, including inflation. We’d need to be extremely concerned to not want to own our best businesses. We’re not there.

Finally, a few further thoughts on the Magnificent Seven. It’s highly unusual to have such a concentration of capitalization in such a small number of companies, but that’s simply a reflection of how dominant each one is. Expert and amateur investors alike believe they are winners no matter the environment, and the AI boost is just getting started. But there is one risk that may be underappreciated. Most are as near to monopolies as we’ve seen in decades. This has not gone unnoticed. The number of times a few of the Seven have been sued and fined for anticompetitive practices is too many to tally. As they position to dominate generative AI, it may cross a line with governments, especially if AI is disruptive. Monopolies have been broken up before.

Richard H. Skeppstrom II
Chief Equity Strategist