Market Insights: Second Quarter 2023

Declining Inflation and Resilient Growth Push Stocks Higher in Q2

The S&P 500 ended the second quarter and first half of 2023 at a 14-month high following a pause in the Fed’s rate hike campaign, stronger-than-expected corporate earnings, declining inflation, and stable economic data. However, the vast majority of the index’s gains are attributed to the large gains of a small number of mega-cap tech companies, who greatly benefited from the explosion of investor and financial media enthusiasm around Artificial Intelligence (AI). 

As we begin the second half of 2023, while momentum is clearly higher and the improvement in the fundamental outlook gives us reason to be bullish, markets may have already ‘priced in’ many optimistic assumptions. In other words, the market has taken a decidedly positive view on the ultimate resolution of multiple macroeconomic unknowns, but their outcomes remain very uncertain and with the year-to-date rally in stocks, there is now little room for disappointment.

First, the economy has not yet felt the full impact of the Fed’s historically aggressive hike campaign, and while the economy has proved surprisingly resilient so far, we know from history that the impacts of rate hikes can take far longer than most expect to impact economic growth. It’s premature to think the economy no longer has a risk of recession. We should all expect the economy to slow more as we move into the second half of 2023. The key for markets will be the intensity of that slowing.

There has been significant progress in bringing inflation down, as year-over-year CPI has fallen from over 9% in 2022 to 4% in less than a year’s time. However, even at 4%, CPI remains far above the Fed’s 2% target. If inflation bounces back, or fails to continue to decline, the Fed could unexpectedly hike rates and/or impose higher rates for longer, which would weigh further on economic growth.  

Turning to banks, markets have taken the regional bank failures in stride. However, it’s too early to declare an end to the crisis as regional bank stress remains a risk to the economy.

Finally, markets are trading at their highest valuation in over a year, and investor sentiment has turned suddenly, and intensely, optimistic. The CNN Fear/Greed Index ended the second quarter at “Extreme Greed” levels, while the American Association for Individual Investors (AAII) Bullish/Bearish Sentiment Index hit the most bullish level since November 2021, right before the market collapse started in early 2022. Positive sentiment does not automatically mean markets will decline, but the sudden burst of enthusiasm needs to be considered in the context of what is a still uncertain macroeconomic environment and markets no longer have the protection of low expectations and valuations to cushion declines.  

The Primoris Wealth Advisors Team