The second quarter of 2023 was another good one from a market perspective. A clear turnaround from what we saw during 2022. The S&P 500 was up a very strong +8.74% for the quarter and 16.89% YTD. International markets were up +1.87% for the quarter and 9.66% YTD. Emerging markets were down slightly at -0.08% for the quarter and +3.46% YTD. The general bond market was down -0.84% for the quarter and +2.09% YTD. Short treasuries were down -0.62% for the quarter and +0.95% YTD.
Portfolios continued their positive moves as was seen last quarter. Equities (stocks) had gains while bonds were a slight drag on performance. Last quarter we thought that we might be starting to see a recovery in bonds happening, but that has not yet happened. Overall bond losses were small and we still believe a recovery is coming, but it seems we are going to need more confirmation from the Federal Reserve (Fed) that interest rates will stop increasing. Because of what the Fed is doing, it seems the equity rally is getting started before the bond recovery we were expecting. For portfolios our Tactical model had a good quarter, with some good tactical investment choices. Our Strategic model also did well, slightly outperforming the Tactical model. The Momentum model, which saw the model signal change in March from U.S. centric investments to Global investments for the first time in a long time, did well in April and most of May, but then started to falter during June. The latest signal has now shifted back to U.S. centric investments, so we will make that change during the third quarter. The Momentum model underperformed both the Strategic and Tactical models, based mostly on the drop seen in global investments starting in June.
Q2 2023 Notes
The Federal Reserve (Fed) raised interest rates by 25 BPS in May to the 5.00% – 5.25% level. The Fed decided to pause rate hikes in June, but interestingly, said they expect rates to go up at least one more time in 2023. My expectation is that we will see two rate hikes at 25 BPS each with the Federal Funds rate ending this cycle at 5.50% to 5.75%. This level is higher than most analysts expect, but from our view we think it is what is needed to get inflation moving closer to the 2% target. Part of the reason this interest rate process has been so tricky is that the effect has been so variable. For example, in February the Consumer Price Index (CPI) inflation rate was 6.0%, then in March the rate was 5.0%. That -1.0% change was considered a very positive inflation move. If we consistently could move 1.0% per month we would get back to 2.0% in just another three months. Then in April the CPI inflation rate came in at 4.9%, only 0.1% lower than March. At that rate it would take 29 months to get back to the 2% target. In May the inflation rate went down to 4.0%, another good -0.9% move, but that monthly variation makes it very hard for the Fed to know exactly what the progress is. We believe this is why they decided to pause in June. Overall, we think inflation is still too high and that is driving our rate increase expectations. Changing gears a bit, we’ve talked about the M2 money supply in the past and we want to come back around to it now. As we’ve mentioned previously the M2 money supply increased dramatically during the pandemic era of 2020 and 2021. From February 2020 to September 2021 the M2 money supply increased by 28%. In a normal year the M2 money supply increases about 6%. That large increase in money has been an underlying cause of the inflation we are fighting today. But, in all fairness, the Government programs instituted to help struggling businesses and families during the pandemic is part of the reason and justification for such a large M2 change. Since September 2021 the M2 money supply has shrunk by almost 11% and is currently at a level that could have been expected if the M2 money supply had grown by the normal 6% per year over the last three years. For us this is encouraging that we may very well be closer to normal from the M2 glut we experienced. It is also why we believe the Fed will succeed in reducing inflation to the target level and that we may not end up in recession. We are currently in the 40/60 camp of thinking a recession could happen. That’s a little better than the 50/50 camp we were in last quarter.
Globally, we want to engage in a topic we haven’t covered before, and that is the country of China. Clearly, the U.S. remains the global hegemon economically and militarily, but China is pushing to challenge those roles. But, it gets tricky because the economies of the U.S. and China are quite intertwined with significant exports going from China to the U.S., so China has be careful to maintain relations to keep those exports moving. Further, China relies on the U.S. for a lot of its investment and technology. If China breaks too far away from the U.S. those channels will disappear. So, we have two nations in strategic competition, but that have ties that prevent them from becoming too untangled. Both countries need pragmatism to not only avoid confrontation, but to continue economic progress.
Speaking of confrontation, that leads us to talk about the military aspect of the U.S. and China competition. This topic comes up often, and though we do not feel a confrontation is eminent, or even likely, it is worth considering. For starters, we have to assume that the concept of mutually assured destruction would prevent either side from using nuclear weapons. That said, any non-nuclear military conflict with China would occur at, or near, the China mainland. China simply does not have the naval resources to project an attack on the U.S. mainland. The U.S. is surrounded by oceans. Thus, we have a U.S. assault taking place either via the Taiwan path, or the South China Sea path to China proper. Here the U.S. has absolutely dominant naval power from its eleven aircraft carriers, nine helicopter carriers, 68 submarines and 92 destroyers. All far greater in number than China has. The U.S. would not engage in a direct amphibious assault on China because of their large land army forces. Instead, the U.S. would bomb China from the sea to a (hopeful) point of capitulation from the guns of its destroyers and submarines. China has anti-ship missile systems that would work to reduce overall U.S. firepower. And they would undoubtedly have some effect. But the U.S. has ship protection technology that includes soft protection, such as guidance jamming systems to steer incoming missiles off target, and hard protection such as high-energy lasers to take out incoming missiles. Again, this war is the last thing either country wants to have happen, and it would be an awful thing, but the U.S. is a much stronger military force, in our opinion. China knows this and for that reason is unlikely to push too hard. Pragmatism wins the long run.
As always, we will watch and research the global economy and make investment choices to the best of our ability for each and every client portfolio. If you have questions about your portfolio, our views expressed in this letter, or anything else financial, please do not hesitate to call.
Barron Financial Group, LLP is a fee-only Registered Investment Advisor regulated by the Securities and Exchange Commission.
This newsletter is for general information only and should not be considered investment advice. Investors should consult with a trained investment professional to discuss their particular situation.