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The Brave Report: Market Commentary for Q2 2023

Click here for .pdf version of this report: The Brave Report-2023Q2

What recession?  Markets continue to grind higher as investors price in a soft landing for the economy and only perhaps a mild recession. This performance has been primarily driven by a rush to the large tech names that got beaten up last year. This is partially because these companies have been able to maintain their profitability, but they are also being viewed as a safe place to park assets in case data turns negative. I do think markets have been a bit overly optimistic so I would not be surprised by some profit-taking at some point.  However, if the economy weakens more than expected then we could see a rush into short-dated treasuries.

Market Overview

During the second quarter, the markets added to their first-quarter gains. Although, there continued to be a large performance gap between the major indices. The Dow industrials gained an additional 3.4% and the S&P gained 8.3%. The NASDAQ continued to be the big outperformer on the year, adding 12.8% bringing its year-to-date return to around 31%. The NASDAQ was the big underperformer last year but that has reversed as investors have flocked into some of the big tech names.  Even with the gains we have seen I continue to see the large tech names outperforming as they seem to be the safety trade while other uncertainties exist in the markets.

On the fixed income side, rates continued to rise after being range-bound for much of the quarter. The Fed has hinted that future rate hikes may be needed, and this has put more upward pressure on rates.  After trading around 3.5% for much of the quarter, the rate on the 10-year jumped to end the month of June at a yield just above 3.8%.  Rates across the curve have continued to rise with the short end of the curve breaking above 5%. The spread between the 10-year yield and the 1-year has now reached a level that we haven’t seen since the early 1980s. Historically, this inverted yield curve normally predicts an impending recession, but we will still have to wait and see if the Fed can orchestrate a soft landing for the economy while reigning in inflation.

Inflation pressures, rising rates and the prospect of a recession have still been the driving factors in this market. The question remains of how high the Fed will need to raise rates to get inflation back to their long-term target rate and if they can accomplish it while limiting the damage to the overall economy.

So far economic data has come in mixed.  We have seen some downward pressure on inflation, but we also continue to see strong jobs data coming out which indicates that the economy is still quite strong and can handle more rate increases.  The Fed has hinted as much.  Their expectation is for a few more hikes but at a much slower pace.  We have definitely seen weakening in certain parts of the economy but overall, the economy has remained resilient.

As we enter earnings season, we will start to get a much better picture of how the economy is performing under the surface.  I predict there will be some definite winners and losers.  I also think companies will continue to express a much more cautious outlook in their guidance as economic uncertainties for the next few quarters will make it difficult to project future growth and profitability. I also predict we will start to see the impacts of increased financing costs negatively impacting earnings and adding to the uncertainty, especially for smaller companies.  Larger companies will be able to weather these increases much easier.

From an investment standpoint, we have seen money flood into the large tech names so far this year.  The top seven or so names have been responsible for a majority of the gains in the NASDAQ and the S&P so far this year and I see this trend continuing.  Rather than run to just treasuries or cash for safety, investors are using large technology names as the safety trade while they wait out future economic data.  These companies have continued to grow and be highly profitable.  They were also some of the names that were beaten up the most last year so had a lot of upside potential going into the year.

I still remain cautiously optimistic as we play the waiting game on more economic data. I do think the markets are currently pricing in a very soft landing and might be a little overly optimistic.  The reason I remain cautious is that if we start to see economic data deteriorate or the Fed is forced to raise rates more aggressively then we could see a selloff in risk assets and a rush into safety.  This rush to safety would be in the form of buying short-dated treasuries along with the large tech names.  With the 2-year paying around 5%, it is not a bad place to park some excess cash while we get more clarity on the direction of the economy.

While I think large tech will continue to outperform, if you have made some money in the large tech trade so far this year, it would be appropriate to trim some of this exposure as it probably represents too large of an overweight.

Strategy Commentary

I continue to maintain a relatively neutral stance across the entire allocation.  As I mentioned earlier, I think the markets are currently pricing in a very soft landing for the economy.   If this continues to play out then I am comfortable maintaining my current exposure. However, if the Fed is forced to raise rates again or we see some pronounced slowing of the economy then I will look to raise some cash and wait things out in short-dated treasuries.  I do think we will see some continued volatility as new economic data comes out but we will need to see true directionality from the economy to make any large-scale changes.

Domestically, I am maintaining increased exposure to large technology, communication services and consumer discretionary.  I have also made some slight shifts away from some more defensive value exposure and back to large-cap growth. If the soft landing doesn’t play out as expected I do think some technology names will sell off, but I also think the larger profitable ones will receive inflows as part of a flight to safety.

Internationally, I missed out on some opportunities in the first quarter so have increased exposure slightly over the past few months.  Most of this increase has been in developed large-cap exposure.  The conflict in Ukraine and the potential ripple effects from the war still prevent me from increasing my exposure much more.  I also continue to keep an eye on emerging markets names but my focus has shifted slightly away from China and I am much more closely watching other economies, such as India.

On the fixed income side, I continue to add to the short end of the curve.  The yields on short-dated treasuries continue to rise and I have been rolling maturing treasuries along with excess cash into new ones. If the markets are wrong and we do not see a soft landing then treasuries will be the place to weather the storm.

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