The Pinnacle: June 2023

July 17, 2023 TallRock Capital

JUNE 2 0 2 3 • I S S U E 31

June Markets

The end of June marked the end of the first half and second quarter of 2023. This has so far been a year which has seen opposite narratives play out to what was seen in 2022. Large-cap growth stocks which were hard-hit in 2022, have performed strongly, boosted by enthusiasm regarding artificial intelligence (AI). After being hit especially hard in 2022, government bonds have reported only a modest increase YTD.

US equities experienced strong performance in June which boosted overall quarterly performance with US stocks finishing the quarter in the green. Gains in June can largely be attributed to the easing of tension in the market after an agreement was reached by US state officials in early June to extend the debt ceiling until January 2025. While the market never priced in the US government defaulting on its debt it certainly cannot be denied that tension was felt by certain market players as the deadline for agreeing a deal approached.

In terms of fixed income, US investment-grade bonds posted losses over the quarter, while still outperforming treasuries. US High-Yield bonds experienced gains during the quarter. This came as the US Federal Reserve (Fed) continued to raise interest rates during the quarter while pausing in June after more than a year of consecutive rate hikes. It is predicted that the Fed will raise rates on two more occasions, which could mean further downside for bond prices. Inflation fell to 4% year-on-year in the US for May, the lowest level in about two years. With inflation nearing its 2% target, the Fed will be hopeful that they can stay on course with two further rate hikes being enough to bring inflation down to target.

While not experiencing gains as strong as in the US, Eurozone equities still modestly climbed higher during the second quarter. The European Central Bank (ECB) continues to be unmoved on its path of higher rates for longer, despite, according to preliminary readings, inflation has fallen for the third straight month in June to 5.5%. Notably, within the global fixed-income market, Italian government bonds have been the best-performing asset this year alongside high-yield credit. The Eurozone experience only a minor decline in GDP of 0.1% for the first quarter of 2023. The first half of 2023 will be defined for the Eurozone as a period when the region continued to show resilience in the face of tough domestic and global economic conditions.

In the UK, major news came from the Bank of England (BoE) in June. While raising rates by the expected 25-basis points in May, the Bank decided to reaccelerate rate hikes to a higher-than-expected 50 basis points in June. Recent inflation numbers showed that YoY inflation remained unchanged at 8.7% in the region for May as the region continues to lag behind its developed market counterparts in its fight against inflation. Unlike the US and the Eurozone, UK equities have fallen over the second quarter. This is largely due to fears of stagflation driving market sentiment in the UK. Stagflation is a situation in which persistently high inflation is accompanied by minimal growth.

Asian emerging markets equities mostly declined over the second quarter. Chinese equities were amongst the worst performers in the region as momentum from their post-lockdown economic restart faded. To try and regain some of this momentum, the People’s Bank of China (PBoC) cut its key benchmark lending rates in June. The one and five-year loan prime rates were both cut by 10 basis points to 3.55% and 4.20% respectively for the first time in 10 months. Indian equities performed well, while Singapore equities ended the quarter in negative territory.

A topic that has been on the mind of investors for more than a year now has been the extent to which central banks will be willing to go to fight inflation. It is expected that the Fed will be the first of the major central banks to deliver their final rate hike after two further rate hikes. This will be critical to watch going forward as it is likely to have effects on the performance of different asset classes.

Navigating Second Quarter 2023 Earnings Season

The second quarter earnings season of 2023 is underway, presenting both opportunities and challenges for investors. While a significant number of S&P 500 companies have issued positive earnings per share (EPS) guidance, experts warn that the market's reaction may not mirror previous seasons and may be more muted.

There has been contrasting perspectives and factors influencing market sentiment during this earnings season. An encouraging development in the second quarter earnings season is the higher-than-average number of S&P 500 companies providing positive EPS guidance. The term “guidance” is defined as a projection or estimate for EPS (or revenue) provided by a company in advance of the company reporting actual results such as a preannouncement. With 46 companies issuing positive guidance, this represents a notable increase compared to recent quarters. In fact, the second quarter thus far has seen the greatest amount of S&P 500 companies issue positive EPS guidance since Q3 2021. Sectors such as Information Technology and Industrials lead the way in terms of positive guidance, showcasing potential growth opportunities.

Market strategists, including Morgan Stanley's Mike Wilson, emphasize that the market's response to "better than feared" earnings is likely to be subdued this time around. Skyrocketing valuations and the potential for higher for longer interest rates pose challenges for US stocks, which need to exceed expectations to sustain the previous rally. Consequently, companies' ability to boost forecasts and provide positive guidance becomes crucial in maintaining investor optimism.

In the past, earnings seasons have generally yielded positive outcomes for equities, resulting in market gains. However, expectations are shifting, and analysts anticipate a more tempered response, even if earnings reports are strong. While the S&P 500 experienced a robust 16% rally in the first half of 2023, concerns over profit downgrades and a potentially choppy market outlook for the remainder of the year are still prevalent.

As earnings projections for the second half of the year face potential downward revisions, the significance of company guidance for future quarters becomes increasingly vital. Analysts and investors will closely monitor these projections, looking for indications of a sustained recovery and potential catalysts for stock performance.

The second quarter 2023 earnings season presents a mixed landscape for investors. While a higher number of S&P 500 companies have issued positive EPS guidance, experts caution that market expectations have reached a higher threshold. As earnings reports unfold, it will be essential to assess companies' ability to surpass these expectations and provide favourable guidance for future quarters. Investors should remain vigilant and factor in potential challenges such as profit downgrades and the impact of interest rate trends in navigating this earnings season effectively.

US-China Relations

The global economy has many prominent and important relationships between different regions. Few are more important than the relationship between China and the United States. Tensions have been high recently due to varied factors, such as sanctions imposed by the US government on Chinese companies operating in the US. Despite this, US Secretary of the Treasury, Janet Yellen’s, recent visit to China is thought to be a step in the right direction to ease some of these tensions.

Relations between the US and China became markedly worse when the Trump administration took a tough economic stance against China back in 2018. This ultimately led to a trade war and tensions have soured further with various sanctions since then. These sanctions range from limiting the sale of semiconductors to China to limiting which Chinese listed companies American retail investors are allowed to buy shares in, amongst others. Sanctions have been imposed in the other direction as well. In February of this year, China imposed sanctions on two US companies for selling arms to Taiwan, which was seen as an indirect threat to China as it is a region that China continues to claim as its territory.

After US Treasury Secretary Yellen’s visit and over ten hours of meetings, China has called for the US to take “practical steps” over their concerns regarding sanctions against Chinese companies. This shows the desire of China to improve relations beyond just positive talks and to call on the US to make compromises to improve relations. With Secretary Yellen’s visit to China, it is clear that the US desires China to do the same to improve relations. Both sides will of course be aware that compromises will need to be made and given the tension over the past years it remains to be seen how quickly solutions can be found on certain issues.

While Secretary Yellen’s visit to China came far from providing any definitive solutions it did signal the willingness of both sides to negotiate. In addition, it should be seen as recognition from both regions of the importance of their relationship within a global economic context. Yellen emphasized that the US is not looking to disassociate itself from China, and any movement of investment away from China is rather down to the US wanting to diversify its business abroad. Yellen also emphasized China’s economic development should be seen as an opportunity rather than a threat to the US.

From China’s perspective, Yellen’s visit was an opportunity to raise 5 key concerns. These involved recent product bans, export controls, investment restrictions, company sanctions, and extra tariffs which the US had imposed on China and its companies. China arranged for key state officials to be present at the meetings with Yellen, including the People’s Bank of China (PBoC) Governor, Zhou Xiaochuan, showing a clear recognition from China of the importance of these meetings. In addition to this, Deputy Chinese Finance Minister, Liao Min, released a statement after the meetings, saying, “Strengthening cooperation between China and the United States is the practical need and the correct choice of the two countries.”

As mentioned, while no solutions on key issues were arrived at during Yellen’s visit to China, the importance of having both sides at the table and negotiating cannot be understated. Both sides have acknowledged the importance of their relationship with these talks to themselves and the global economy as a whole.