Quarterly Edge Webinar: Q3 2023 Market Analysis

Daniel Dusina: Thanks again for joining. We have another edition of the Blue Chip Partners Quarterly Edge, led by myself, per usual. I'm Daniel Dusina, Director of Investments here at Blue Chip Partners, for those of you who I have not met. As usual, we'll be walking through some of what we would view as the key themes for the upcoming quarter. And the full Quarterly Edge, as always, is available on the Blue Chip Partners website in the blog section, where you can see the drawn out language as well as some of the charts and data we'll walk through today. But realistically, just as we always do, I've tried to point out what I view as three of the key themes for the investment landscape for the upcoming quarter. Generally speaking, we'll look to have one of those be economic related and then the other two somewhat market related at varying levels of intensity.

For this upcoming quarter, and I would say you're already seeing a lot of this play out, but from an economic perspective, we will look to unpack the current standing of the domestic landscape on the economic side. Certainly not perfect, but a lot more encouraging than I think a lot of investment participants would have said or thought coming into this year. Next, we'll talk a little bit about some observations that I have from the first half of this year and what I think that could mean for the second half of the year in equity markets, most notably looking at some very significant concentration in the equity markets. A very top-heavy S&P 500. And also, unpacking a little bit of interesting correlation that we're seeing between a certain subset of the equity market and interest rates.

Finally, we'll talk bonds. More specifically, we'll talk about what feels right to do in the moment and what is actually right for the future and that'll make a lot more sense if you've already read the Quarterly Edge or if you keep listening until the end. Keep in mind, as always, you can put forth questions using the functionality in GoToWebinar. I will look to address any of those at the end.

So, just as a jumping off point, from an economic perspective, what I would say is coming into this year, certainly plenty of talk around recession, stagnating data, whether it was employment or overall domestic GDP. But where we find ourselves today is after seeing remarkable resilience from economic data overall in the first half, honestly in decent standing. There are some bright spots and some more causes for concern. But what I would say is overall, the remarkable resilience in the face of ten successive rate hikes from the Federal Reserve has been pretty impressive.

It was interesting to observe in the middle of last year, I think everyone was forecasting a recession to be taking place in the first quarter of 2023. If you looked at the fourth quarter of last year, everyone pushed that out to the back half of 2023. And where we're at today, we have the sell side rapidly marking down the recession expectations and those who still are in the recession camp have pushed that out up until 2024. So, a very dramatic change from where were just six months ago. And again, I think that's all founded in data. What you're seeing on the screen right now is just a pretty simple outline of some key economic indicators and what we think about them in their current state. What I would say is the consumer always going to be of utmost importance for the domestic economy, given it does account for roughly 70% of US GDP.

Mapping the consumer is always very important, and what we've found this year is that they are in a bit of a sweet spot. Spending has remained relatively robust, but consumers are not overreaching from the perspective of credit utilization, essentially not spending beyond their means. And this is a really good spot to be in because realistically, if you have a reasonable level of employment and consumers are willing and able to go out and spend, that can support an economy for the foreseeable future. Certainly, savings have dipped a little bit relative to where they were, say, two years ago, but that COVID stimulus really did help things. Right now, what we're seeing is savings rates actually at a reasonable level and consumer balance sheets are at a pretty healthy rate right now.

The US dollar, that certainly has potential to be a bright spot. We've seen that move quite a bit, whether it was last year with rapid acceleration in the US dollar relative to other currencies on the back of higher interest rates. We have seen a little bit of a falling off on that front this year, I think through expectations for future rate cuts. But realistically we've seen some stabilization there and either way it really doesn't feel like the US dollar will be cause for anything tumultuous from an economic standpoint. On the neutral side of things, I think it's important to note that we just had first quarter GDP revised upwards significantly. So overall constructive, but I think there is at least on my end expectation for this to be quelled a little bit as we move throughout the back half of this year and into 2024. It's more slow and steady. I wouldn't be expecting banner growth from a GDP perspective, just given overall slowness as we kind of see it moving forward.

The labor market, I've been harping on the labor market as probably the most important economic element over the last year and a half. A very tight labor market was a very big culprit of inflation as employers had a lot of trouble finding people to fill their seats. What do you do? You go out and you have to pay them more. If everyone's being paid more, they can go out and spend more. If you're spending more and you're willing to pay higher prices, that's inflation. So certainly, with the labor market getting a little bit looser, as measured by something that I look at called the jobs-workers gap, which essentially just looks at the level of employers that are looking for workers versus those that are actually seeking work. We've seen that close significantly throughout the last six months and we expect that to continue, which can be very supportive from an economic perspective because that can again feed through to more reasonable levels of inflation.

 On the inflation side, just as we've talked about over the last two Quarterly Edges, the inflation story is clearly in decline. Realistically, if you want to talk literal CPI prints, it has been since June of last year. But even coming into this year, what we said is that inflation, at least the headline figure, is the Consumer Price Index has been artificially held up by just one area and that was housing. Housing accounts for over a third of the Consumer Price Index. And when you have that artificially inflated and slated to come down over the coming six months, you can actually be pretty constructive, at least from an inflationary perspective. The fact that we haven't seen it really become entrenched is a very good thing for the US. Certainly we're watching core CPI versus the headline CPI, just as core has been a little stickier, but nothing that I would say would be cause for concern.

Other elements, what I would say are more concerning. First, I'll touch on manufacturing. I think the manufacturing story here in the US has been fairly bleak for the last six to eight months. Whatever you look at, whether it's industrial production or the manufacturing purchasing manager indices from market or ISM, they really have not spit out anything that would be too compelling. But I really don't think that this is an overly large cause for concern and it's somewhat to be expected. As you get later in the cycle, businesses will tighten up their belts a little bit and not overextend themselves from a manufacturing capacity standpoint. So, this is to be expected, and I don't necessarily foresee this changing anytime soon.

The other element that I think could potentially be more concerning is just a lack of future business investment. We talked three months ago about one of the impacts of the banking crises that happened back in March was essentially an alternative form of monetary tightening. So yes, we've raised interest rates dramatically over the last year and a half, but the fact that you have a lesser availability of credit and loans, given higher lending standards after the banking failures that happened, that can be very inhibitive from a business investment perspective. As capital is less available, whether it's a healthcare firm that's looking to go out and take a loan to buy machines that help them produce parts for medical devices, or it's a dental operation that's looking to expand. Getting money is harder and that will inhibit some expansion and growth, which I think ultimately could end up being a bigger issue than anything that's really being harped on or talked about in the media today.

Overall, we're in good standing. I would say that certainly relative to coming into this year. I'm not going to call it a Goldilocks scenario right now, but there certainly are elements of that emerging with slow and steady consumer, reasonable levels of inflation and unemployment that still remains in check, but likely will go a little bit higher, which I actually view as a good thing just for the health of the economy overall. Not anything like a doomsday scenario that we thought it might be coming into this year.

Taking a step back and just changing gears a little bit, we're going to talk a little bit about the equity market, both from the perspective of some concentration that we see as well as an interesting correlation that we've seen take place between interest rates and a subset of the equity market this year. What I would say is that after we saw in 2022 a little bit more of an easing of a very high level of concentration in the S&P 500, concentration is most certainly back. When we're talking about concentration, we're talking about just five names in the S&P 500 index accounting for 25% or more of the overall index weight. Again, this is something that can ebb and flow, but over the last five years or so, we've really seen this start to explode. We've gotten to a point where the S&P 500 has never been this top heavy before.

There is obvious inherent risk with concentration in just a few names, but I think that right now it's more important to call it out because it's not that there's anything fundamentally wrong with these businesses. We are constructive on all five of the largest companies in the US today, but the fact is that the valuations that you're paying for these businesses by and large have become very rich. From an entry point perspective, it doesn't really feel like now is the time to hop on the bandwagon for what has worked very well this year.

That's just a way of saying we're a little bit cautious on the top-heavy stuff right now. Realistically, what we've been saying, at least in client conversations, is that if we want this equity market to continue its trajectory through the end of 2023, it's realistically not going to come from the same five names or seven names that have worked really well this year. It has to be a more robust broadened out rally for the other 493 or 495 names in the S&P 500. And it's very constructive that we've seen that take place realistically over the last month and a half.

To start the year, the S&P 500 Equal Weight Index, in which those top five names don't have as large of a weight, dramatically underperformed the standard capitalization-weighted S&P 500 Index that's completely changed over the last month and a half. And what that tells you with the S&P 500 Equal Weight actually outperforming the cap-weighted index, that tells you that the rally has broadened out quite a bit. And again, that's constructive, at least from our seat.

The only other element that I will note is that when we look at huge elements or huge times of concentration like we have today, this isn't something that is set in stone. These five names are the biggest businesses in the US today, but that doesn't mean that they will be in 10 years or 20 years or 30 years. Look at the graphics you're seeing on the screen. You have companies that at points in the 1980s, like IBM made up over 4% of the S&P 500, and they're at just 30 basis points or 0.3% today.

I just think it's important to call everyone's attention to the fact that, yes, these are shiny objects and yes, they're good businesses, but there's a lot of other good businesses out there as well. And that's really where we're spending more of our time, is identifying businesses that have not necessarily kept up with the market rally this year, but realistically should do so going forward.

Another interesting element of market returns through the first half of this year was the relationship between Nasdaq companies and interest rates. Generally speaking, companies in the Nasdaq composite tend to skew a little bit more towards, I would say less mature, higher growth companies. And companies like that generally have an inverse relationship with interest rates. When interest rates go up, these companies have generally been sold off. When interest rates are declining and money is easier, those companies generally have been beneficiaries of investor sentiment. That's because if you have a company that's younger and still growing very quickly, much more of their growth is going to be fueled by things like loans. When you have higher interest rates, obviously that becomes a little bit more challenging. Also, because just from a pure valuation perspective, high growth, younger company, more of their valuation is going to be put in the out years, more of their profitability. As you discount that back using interest rates that are higher, that arrives at a lower fair value.

So, long story short, Nasdaq companies and interest rates have typically been inversely correlated. And that's exactly what we saw throughout all of 2022 just about, and for that matter, for the first four months of this year, that was the case as well. What's very interesting is that over the prior two months, at least as of the end of June, we saw this lack of correlation that previously existed get completely flipped on its head. You can see in the graphic on the bottom of the screen the correlation between the US 10-Year Treasury Yield and the Nasdaq Composite prior to the beginning of this year was -0.86. So just about as negative as you can get. Correlation goes from negative one being very inversely correlated, to one which is very positively correlated. When you see that correlation flip from -0.86 to +0.82, which is what was observed from the months of May and June of this year, that's a bit of a head scratcher for me.

Essentially, that tells me that something's got to give. And what that something is either A: interest rates have to come down, that's basically what the equity market is expecting; or B: the Nasdaq composite needs to reset, because if we are going to have higher interest rates or potentially elevating interest rates still from the Federal Reserve, then this relationship needs to come back into balance. And so, it's not necessarily a call to action or anything like that, but I would say the path of least resistance should we get higher interest rates right now, the market's pricing in at least one more rate hike from the Fed on July 26. The path of least resistance for the Nasdaq is down. I would submit that the correlation, or lack thereof that we have previously seen prior to 2023, will return. It's just a matter of when. This is just another way to cement the point that I don't think we need to be reaching for the valuations that are pretty lofty at this time in some of the shiny names that have worked really well this year.

 Final theme for the upcoming quarter, third quarter of 2023, is around fixed income. More specifically, it's around how the bond market can give and the bond market will ultimately end up taking away at some point. And what I mean when I'm referring to the give and the take is that when you have significantly higher interest rates, there are relatively risk-free assets that are paying pretty attractive levels of income. What I'm referring to is something like money market funds. When you have money market funds that are essentially riskless and yielding 5% and potentially beyond that, why would you really look anywhere else? If you told me that I could obtain a 5% yield in a certain way in anything just two years ago, I mean, I would be all on board. Sign me up.

Realistically, while I do think it's prudent to continue to hold at least a portion of an investable portfolio in these cash like securities, I think it's time to start weaning off of them. Because of the nature of these vehicles, their return is temporary, they fluctuate with the level of interest rates. As we get a lower level of interest rates, which we do think will end up happening at some point next year, it's going to be important to have already locked in some alternative way to take advantage of more stable securities. When the money market funds end up flipping to a less compelling offering, the bond market will likely have moved before that. If you wait until interest rates actually get cut, I think you're going to get left behind. And so realistically, the proposition today is as you look at the market, the traditional bond market that is, there are many high-quality offerings that are yielding A: very close to 15-year highs, and B: have embedded potential for capital appreciation, which by the way is something that money market funds cannot offer.

I think that as we look at the next three months, something that I would suggest is taking a look at hefty cash-like security balances and starting to work those down. No one's saying you have to rip the Band Aid off, but as you kind of unwind those positions and deploy into the bond market, at least in a high-quality manner where we view as fairly attractive, I think that you will not be disappointed if you look back at the returns on your statement over the three years to come. Realistically, I don't think that everything in the bond market looks attractive. To me, things like high yield, you're really not getting paid enough to take on the risk that's inherent in those types of bonds. But things like Treasuries, like municipal bonds, like investment-grade corporate bonds, all of these are yielding close to 15-year highs.

As you'll see in the graphic on the bottom of this page, at least from an investment grade corporate bond perspective, you have typically been very well rewarded on a forward return basis when investing at higher starting yields. This is kind of inherent in bond math and we won't have a conversation on that today because I'm trying to keep everyone awake, but realistically I think it kind of comes down to what are your expectations? Yes, if you have a need for cash in the next six to twelve months, then taking advantage of those money market funds and cash-like securities is appropriate. But to the extent that your time horizon is longer than that and you don't have a significant need for cash buffer, now is the time to start legging into the bond market in a traditional way. At least that's what historical data would tell you.

With that, I will conclude my prepared remarks and I will look to answer any questions that have come in from the audience. I'll just take a quick look to see if we have any that have come in. It looks like we have one that is related to the equity side of the equation essentially asking, so if you don't like the top five names, what are some things that you do like? Well, what I would say is it's certainly not just a valuation conversation and it's not just bottom fishing, but there are a lot of areas of the market that have not kept up this year that we kind of have trouble finding reasons for.

When I look at certain sectors, like healthcare, like utilities, I would say healthcare is probably our most favored sector, most interesting sector for us right now because, number one, the sector itself, it's a traditional defensive sector, but it also can offer you elements of growth that I don't think you can find in the other traditional defensive sectors. So just a better growth profile in healthcare relative to sectors like consumer staples or utilities or the telecom businesses. And they've been beaten down this year and it's kind of been across the board. So certainly, you saw some of the health insurers, the HMOs, get chewed up a little bit because of expectations for higher utilization, which weighs on their costs, obviously. But really, it's been everywhere. Pharmaceuticals have been beaten down, the devices firms haven't really recovered as we thought they would. At this point we're taking a pretty close look at firms across the sector in different industries. Ultimately, we'll probably end up taking some chips off the table in what has worked really well this year and has run to what I would say five-year high valuations and moving our chips towards some of those elements in the healthcare sector, which realistically we can be constructive on. If you find high quality businesses, that's great. If you find them at a good price, that's even better. I would say that's one area where we're fairly constructive.

Second question that came in is what about high-yield bonds exactly do you not like? Well, I would say traditionally speaking later in an economic cycle, which is where we find ourselves today, that's not necessarily the best time to pile into high yield bonds. Just from a sheer kind of borrowing perspective. When you have a tighter economic scenario, which comes with later in the economic cycle, smaller businesses and those that are generally issuing high yield debt, those that are less capitalized, can tend to feel the pinch first. What you get then is some level of default rates picking up. And while we're not expecting a huge slew of defaults, what I would say is there is possibility of that over the next twelve months.

The second leg of this is generally speaking, when you have high yield bonds at average prices of, call it $85 to $88 on a relative to $100 par, the spread over the traditional investment grade corporate bonds is much wider than it is today. So that's basically just another way of saying that what's baked into high yield bond yields today is not rewarding you for the risk that you're taking on. And that's kind of where we come back to not getting greedy. I mean, when we've got investment grade corporate bonds who are inherently higher quality issuers and more well capitalized, at least based on their credit ratings, if you've got these bonds that are offering you yields that you haven't been able to obtain in 15 years and the average forward return on a two-year basis is over 6%, what's really the question?

How greedy do you have to get? Especially for a part of an investor's allocation that's supposed to really just be a ballast, at least for us. That's not like a super high return generating portion of our clients’ portfolios. That's really what we reserve the equity side of the business for. Either way, certainly there's going to be opportunities on a security specific basis and high yield, but it's not an area we're super interested in right now. Just because we don't feel like we're getting the squeeze. The juice is not worth the squeeze.

Well, that's all the questions I have for now. We're getting close to time, so I appreciate you guys all joining on behalf of Blue Chip Partners. I'm Daniel Dusina. Hope you guys enjoyed another edition of our Quarterly Edge, and please do keep up with us and our content on our website and on LinkedIn and other avenues.

If you have any questions, you can email myself or another member of the team and we'd love to have a conversation. Thanks again for watching and I will talk to you guys next quarter.