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The continued global economic expansion, amid falling commodity prices and generally disinflationary trends, provided a favorable environment for the prices of riskier assets during the second quarter. The outlook appeared mixed, with a supportive US consumer backdrop tempered by rising interest rates.
Looking ahead, greater monetary policy uncertainty and slowing liquidity could raise the odds that market volatility will return. The valuations of fixed income and non-US equities appeared to price in more of this uncertainty.
Stocks lead among riskier assets: US large-cap growth stocks spearheaded the rally in riskier asset prices, with non-US equities registering more modest gains. Credit-sensitive fixed income categories, such as emerging-market debt and corporate high-yield bonds, posted positive returns, but rising interest rates dragged most bond categories lower. After the broad-based downturn in 2022, most asset categories have rebounded through the first half of 2023.
Despite sharp gains for US large-cap stocks, the 2023 market rebound remained relatively narrow. The top 10 largest US stocks, concentrated in the technology and communications sectors, received a boost from exuberance about the prospects for artificial intelligence and rose more than 40% in the first half of the year. This far outpaced the rest of the market, where the rebound was less pronounced.
Could the hiking cycle be peaking? Global short-term interest rates rose to their highest levels in more than a decade. Most investors expect the pace of rate hikes to slow and eventually stop during 2023, but the impact of the abrupt departure from the ultra-low rates era may weigh on financial conditions in the quarters to come.
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Many economies, including the US, face headwinds related to persistent inflationary pressures and tightening monetary conditions. However, the global cycle does not appear to be synchronized. China's economy continues to benefit from its post-COVID reopening, while Europe has stabilized amid falling energy prices. We believe the US is in the late-cycle expansion phase, with solid near-term momentum but a high probability of greater slowing ahead.
Global services expand despite headwinds: Global services activity accelerated in Q2 even as manufacturing measures stagnated. Central banks tightened policies over the past year at varying speeds and magnitudes. With inflation decelerating in recent months, many emerging markets (EMs) appear near the end of their hiking cycles, while several developed-market (DM) countries appear inclined to tighten policy further to address persistent inflation in core services activity.
Commodity prices and global trade activity deteriorated for the quarter. Prices of both energy and industrial metals have dropped by double digits on a year-to-date basis.
China's structural headwinds: China's economic reopening momentum lost steam during Q2. We expect policymakers to bolster monetary, fiscal, and regulatory support in the months to come. However, structural imbalances—such as excess capacity and leverage, including in the large property sector—pose significant constraints on the potency of stimulus and the upside for China's growth trajectory.
Signs of US strength amid tight credit: Our preferred yield curve—the 10-year less 3-month Treasury yield—inverted further during the quarter. The yield curve has been a reliable leading indicator of recessions, but the timing tends to be variable. Although banking system stress and recessionary fears became less of a concern to markets during Q2, banks further tightened lending standards across multiple loan categories.
Even with tighter lending standards, the household and corporate sectors looked relatively healthy at the end of June and have so far shown limited vulnerability to interest rate increases. Supporting factors include tight housing supply, low consumer debt, and well-capitalized large banks.
Businesses pared back on their job openings and hiring plans, but unemployment stayed near multi-decade lows and labor markets remained very tight.
US consumers looked financially healthy as well, amid record-high net worth and post-pandemic excess savings. Year-over-year nominal wage growth surpassed inflation, marking a positive reversal in real wage growth that is now boosting inflation-adjusted household incomes.
Inflation moderation, but what comes next? US consumer inflation rates continued to decelerate after reaching a multi-decade peak above 9% last year. We believe this moderating trend may be coming to an end and that it will be difficult to return to the stable, low core-inflation environment of the past 2 decades. A big drop in energy prices helped reduce year-over-year total inflation, and additional energy weakness would help boost the chances of continued disinflation.
Many inflation pressures that tend to be more transitory, such as supply-chain disruptions, continued to fade in recent months. However, categories where price increases tend to be more persistent and more reliant on demand-side factors now account for almost all of US inflation. If tight labor markets continue to boost unit labor costs, inflation in services sectors may linger for longer than investors suspect.
Equity markets continued to rally, led by large US technology companies as the perceived beneficiaries of an anticipated boom in artificial intelligence. Globally, developed-market equities outperformed emerging markets, and commodity prices dropped. Riskier fixed income sectors, such as leveraged loans, added to year-to-date gains, but more interest-rate-sensitive ones, such as government bonds, posted losses.
Stock prices: Valuations moved higher for all major regions as stock prices rallied for the quarter. The trailing, 1-year price-to-earnings (PE) ratios for non-US stocks (developed markets and emerging markets) remained below their long-term averages, while the US climbed to well above its longer-term average.
Earnings: Global earnings growth remained challenged by above-target inflation, and monetary tightening. However, global earnings showed some signs of stabilization. Emerging markets remained laggards, with a double-digit earnings contraction on a year-over-year basis. Global earnings growth expectations for the next 12 months remain similar across the world in the low single digits.
Currencies: The dollar appreciated modestly. Interest-rate differentials have been the key driver of currency performance this year, and the dollar benefited as the Fed kept hiking rates. However, that trend is easing as other central banks continue to tighten their monetary policies. On a long-term basis, non-US currencies appear undervalued relative to the dollar.
US Treasuries: As banking-sector turmoil abated, Treasury yields rose and credit spreads fell across most fixed income categories. Most major bond sectors' yields and spreads finished roughly near their averages over the past 2 decades. After many years of very low bond yields and tight credit spreads, fixed income assets may offer relatively better income opportunities with more attractive valuations.
Quarterly Market Update Video
In this video, Dirk Hofschire, Senior Vice President of Asset Allocation Research, examines major themes in global financial markets and presents his investment outlook for the third quarter of 2023.
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