The wall of worry

Are markets climbing it now?

The first half of the year has been much different than most had predicted. After an awful 2022, equity investors’ mood was sour, and most were expecting that this year would be a continuation of the downdraft. There were lots of reasons why the floor would fall out on equities, ranging from a policy error by the central banks to a looming recession, which would weigh on earnings. However, at the halfway mark, things are looking much better than feared.

This year has been far from perfect for investors. In an ideal situation, most would want to see a broad-based move higher in which all sectors participate and everyone wins. That is not the case today as “the magnificent seven” technology giants of the U.S. fueled by AI hype have dominated returns and covered over many “real world” cracks as the performance difference between the market-cap-weighted S&P 500 and its equal-weighted version is at a historic level.

The naysayers will point to the narrowness of the market move as a sell signal. However, looking at that misses a significant point – that the robustness of the economy has surprised many this year. While inflation hasn’t fallen to levels that will allow central bankers to become friendly once again, it has reached a range that will allow them to start normalizing conditions. At the same time, the most aggressive rate hiking path in decades has not broken anything (outside of a few U.S. regional banks). This has caught most off guard and allowed what was a bear market rally to blossom into something much bigger.

Now at the halfway point, the question is what will the remainder of 2023 hold? With the technology sector leading the charge forward, the bull case would require a broadening out of the rally to include the lagging sectors. For that to happen, we would need to have investors become more comfortable with that we will avoid the most heavily anticipated recession in years.

But is that a likely scenario? The recent economic numbers have been impressive, with payrolls and spending holding up, but that doesn’t mean things won’t quickly turn on a dime. For those looking for a catalyst to be worried about, the U.S. yield curve is the most inverted since the 1980s and regional banks remain under pressure. There is also the looming issue around commercial real estate exposure, as the office and retail subsectors struggle in the post-Covid world. Either of these issues could become front-page stories and impact markets. Or what we may see is simply much tighter lending conditions as banks become more restrictive, which will weigh on an already stretched consumer and potentially be the hit to earnings most were expecting.

In the next few weeks, we will begin to hear earnings reports for the second quarter. That, combined with inflation data, will determine the path for the next few months. During summer, when many are on vacation, a choppy sideways market with no direction is probably the most likely scenario as the bulls and bears square off. Then as we head into the seasonally weaker period of September and October, the risk is that earnings will begin to contract and the momentum that carried the technology stocks peters out, so we get our long overdue correction.

Markets do like to “climb the wall of worry” and have done an admiral job so far this year. Will they continue on that path or hit a hurdle along the way? All the negative forecasts to start the year haven’t come to pass yet, but instead of being wrong, maybe they were just early. And that may be reason enough for many to step to the sidelines until we determine the path forward.

Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.

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