Investment Insights

Halfway through 2023, and there is no sign of a recession. When we wrote our last quarterly newsletter in April, we were very cautious about the forward outlook, citing downward earnings revisions, the March stress in the banking sector, and softening in recent jobs data as all signs pointing to a likely recession. As we sit here in July, three months later, equity markets remained buoyant for 2Q23 despite these worrisome signals.

For 2Q23, the S&P 500 rose by +8.7%, but was again outpaced on the upside by the tech-heavy Nasdaq (up +13.1%). In fixed income, broad index returns were slightly negative (-0.8%), as longer duration Treasury rates impacted returns further out the curve, but high yield corporates and Treasury bills posted positive total returns. In combination with positive market returns in 1Q23, investment returns have rebounded nicely through the first half of 2023 after a dismal 2022. Looking at other indicators, for 2Q23, the US dollar index (DXY) was flattish, while the benchmark 10-year US Treasury rate (UST10) rose to 3.84% (up 37 bps). The price per barrel of WTI oil declined by -7% in 2Q23, closing June at $70.66.

A few developments since this spring are noteworthy. Most importantly, the Fed paused its campaign of interest rate hikes and left rates steady at its June meeting for the first time in over a year. However, the “hawkish pause” was accompanied by an update to the Fed’s outlook that has repriced the forward curve and diminished probabilities for rate cuts in 2023. As of this writing, the Fed is on pace to raise rates by another +25 bps to a range of 5.25% to 5.5% at its July meeting, with the possibility of one more hike by year-end. While headline inflation (CPI YoY) continues to decline, core PCE has shown sign of being sticky in the mid-4% range, well above the Fed’s 2% target. The latest GDPNow forecast for 2Q23 real GDP is 2.4%, up slightly from the 2.0% pace in 1Q23.

Through the first half of this year, we have frankly been surprised by the strength of equity markets, as valuations were already somewhat rich based on historicals coming into 2023. The strong performance year-to-date has stretched valuations even further particularly in mega cap tech. For the first half of the year, return on the equal weight S&P 500 was 7%, compared to the market cap weighted return of 16.8%. In fact, the concentration among the biggest tech names has gotten to a point that Nasdaq rebalanced its index to diminish the contribution of the largest companies. We feel it is important to emphasize what this means: well diversified portfolios have lagged the broader market for the first half of 2023 since the rally in the largest seven tech equities is driving the majority of market gains.

Elsewhere in the world, European equities (using the Euro STOXX 50, +19% YTD) were also strongly higher year-to-date, but still trade at a substantial valuation discount to U.S. equities (vs. S&P 500), giving the continent an advantage versus the U.S. on valuation. China showed signs of slowing growth after a post-lockdown burst of activity.

As we look to the second half of the year, there is consensus emerging that the Fed is pretty much done hiking rates. However, there is much less clarity on how long rates may stay elevated. Our sense is that the Fed is committed to avoiding the mistakes of the Burns-era Fed (1970s), when it prematurely cut rates and inflation took flight again. Still, we acknowledge that the current pandemic-driven business cycle is very different than past cycles, and we do not see a recession as a foregone conclusion. Although we still view a recession as the most likely outcome (over 50% chance in the next 12 months), we feel the case for a soft landing has risen.

Given our view that the chances of recession remain elevated, we are maintaining our cautious stance on portfolios, with a preference for “up in quality” fixed income investments. We note that many clients continue to buy short-term Treasuries, and we acknowledge that we have not seen today’s levels on short-term rates since before the financial crisis. However, we encourage clients to think long-term and consider adding duration in their flexible allocations to lock in higher yields for longer, especially as the Fed looks to be mostly done in its hiking campaign. Whenever the Fed does start to cut interest rates, T-bills will be the very first assets to reprice downward in yield. We think most investors would be well served by starting now to shift out of T-bills and into longer duration asset classes.

The fate of the equity market is more tied to the soft landing vs. recession debate than fixed income. Equities may benefit if in a sustained higher inflation regime, because their prices and earnings are in inflation-adjusted dollars, while debt burden stays steady in nominal dollars. This is likely one driver of why we have seen equities unexpectedly outperform this year. However, we do not expect the Fed will tolerate higher inflation, despite some market participants calling for them to move to a 3% inflation target, and ultimately we expect this commitment to lowering inflation will cause growth to slow further. Meanwhile, fixed income should be a win in either scenario: if we get a soft landing, then spreads should be stable and investors get income. In a recession, we expect bonds to rally on lower Treasury rates and show less volatility than equities.

In this newsletter, we introduce our Amerant Views for the first time. These views represent our investment team’s tactical views, for the next twelve months, based on investment valuations and macro trends. We initiate our views with an overweight to investment grade and emerging markets bonds, given attractive yields and relatively stable credit quality. We are neutral on cash and high yield bonds. We initiate at underweight on large cap U.S. equities while neutral on U.S. small caps and developed markets equities ex. U.S. We will endeavor to update these views in each quarterly newsletter going forward. That said, we emphasize that these are not client-specific recommendations, and clients should consider their financial goals and long-term objectives when determining their asset allocations.

We will be looking for opportunities to shift our dynamic allocation tilt back to neutral, but for now maintain our cautious stance given our view that recession is still a reasonable possibility. Despite our conservative view on near-term tactical asset allocation, we continue to advocate investors maintain their long-term strategic asset allocations based on their risk tolerance and investment goals, rather than trying to tactically time the markets. Or, to put it more poetically, Life is what happens to you while you’re busy making other plans.

Notes: Asset class performance is in USD and refers to the following indices: Equities: US Large Caps (S&P 500), Emerging Markets (MSCI EM), Europe (MSCI Europe), Japan (MSCI Japan). Fixed Income: 10-Yr. US Treasuries (BofAML US Treasury Current 10-Yr.), Emerging Markets Sovereign (USD) (JPM EMBI Global), Emerging Markets Sovereign (LCL) (JPM GBI EM Global Diversified), US High Yield (BofAML US HY Master II), US Investment Grade (BarCap US Aggregate Bond), and Developed Markets Sovereign (excl. US) (JPM GBI Global Ex US). Source: Morningstar. (1) Strategy returns net of mutual fund expenses and Amerant Investments standard management fees.

On this table, you can see the returns for the first two quarters of 2023, as well those for the full year 2022.

The second saw positive returns across most all asset classes. Most notably, equities rallied across all geographies led by Europe and the U.S. Fixed income returns were mixed, with 10Y U.S. Treasuries down -1.9% for 2Q23 while U.S. High Yield and Emerging Markets hard currency bonds both had positive returns of 1.6% and 1.5%, respectively.

With the Fed’s rate hiking cycle nearly over, we are reviewing our decision last fall to maintain a conservative stance. We continue to believe that the balance of factors indicates the economy will continue to slow, if not fall into an outright recession. With earnings set to slow, multiples high based on historical averages, and fixed income yields more attractive than they have been in decades, our bias remains to stay in a more conservative posture. We continue to believe that equities are looking stretched on earnings multiples, despite a slower earnings growth outlook. We advocate a very selected approach to equities, with a focus on specific stocks and sectors with conservative multiples, and we recently moved our house view on large cap equities to underweight. As always, we continually review our positioning and will communicate any changes in our views going forward.

⁽¹⁾ Strategy returns based on the total return of the underlying mutual funds, including reinvestment of dividends and change in NAV. Net of mutual fund expenses and Amerant Investments standard management fees. Returns may vary. Past returns are no indication of future performance.

⁽²⁾ Monthly returns before February 2010 are those of the offshore corresponding strategies. For the Dynamic portfolio, monthly returns before November 2009 are those of the Income & Growth portfolio, which is the neutral positioning of the Dynamic portfolio. Dynamic portfolio started in November 2009..

During 2Q23, the Income Portfolio returned -0.1%, the Income & Growth Portfolio returned 1.6%, the Growth Portfolio returned 3.4%. The Dynamic Portfolio, positioned in Income, returned -0.1% during the quarter.

For the first half of 2023, the Income Portfolio returned 3.5%, the Income & Growth Portfolio returned 6.3%, the Growth Portfolio returned 10.2%, and the Dynamic Portfolio returned 3.4%. These returns are a positive turnaround trend from the negative returns in 2022.

In late 2022, we positioned portfolios more defensively to be better prepared to withstand an environment of increased volatility due to continued fears of recession and geopolitical risk. Looking ahead, we are maintaining our cautious positioning given the heightened economic uncertainty and recession risk. That said, we acknowledge that the case for a soft landing in the economy has risen. We will likely revise our cautious stance in the coming months if we see further evidence of a healthy economy. On the other hand, if we see building evidence of stress in employment or consumer financial data, we would likely keep our conservative positioning. We would prepare to add risk if valuations become attractive and breach our downside targets.

As always, we take the trust you have placed in us very seriously. In our day-to-day operations, we continue to follow current events and the reactions of the markets closely, and we stand ready to adjust your portfolios accordingly.

To obtain more detailed information on our market views or the performance of your advisory portfolio, please contact your investment consultant at Amerant Investments by calling (305) 460-8599.

Sincerely,

Amerant Investments, Inc.

amerantbank.com