As Good As It Gets?

In Short

• Despite mixed economic signals, July ended with the U.S. economy appearing to be “full steam ahead” with equity markets continuing to rally
• Earnings results and forecasts coming out of S&P 500 companies have reflected company-specific drivers and risks
• China’s slow reopening creating some challenges amidst its ongoing shift to more consumer-focused economy
• In portfolios, we seek to neutralize our positioning by moving to our long-term strategic asset allocation targets while considering extending duration and looking to private markets for additional diversification

Possibility of a Soft Landing

July ended with the U.S. economy appearing to be “full steam ahead” despite consensus expectations of an imminent slowdown in 2023 amidst the fastest series of interest rate hikes in U.S. history. Equity markets continued to rally, reflecting a further broadening of returns beyond mega cap tech stocks. The S&P 500 Index posted its fifth consecutive month of positive returns in July with nearly 90% of members above their 50-day moving averages.

As a result, inflation measured by Core Personal Consumption Expenditure (“Core PCE” – the Federal Reserve’s (Fed) preferred inflation gauge) reported in-line with consensus estimates and inflation measured by core CPI (“Consumer Price Index” - a basket of goods and services excluding food and energy) missed consensus estimates. Taking these into consideration, the FOMC decided to raise its policy rate 25 basis points to 5.25% - 5.50%, its highest level since early 2001. Following the meeting and reflecting on Chairman Powell’s comments, the probability of a pause in September is 82.5% (CME FedWatch). In fact, Fed staff are no longer forecasting a recession and believe it is possible for inflation to return to target without high levels of job losses, bolstering the “soft landing” narrative. Americans are also feeling more confident about the economy. During the month, consumer confidence hit its highest level since mid-2021, helping to drive the first preliminary read of 2Q GDP to 2.4% quarter-over-quarter (SAAR) vs 1.5% consensus.

Finally, the labor market showed some signs of slower growth in July, with non-farm payrolls (NFP) reporting at its lowest level since 2020 (+187k), data that will likely be well-received by the Fed. We must also consider that wage growth came in hotter-than-expected alongside the favorable NFP print, and it will be difficult to achieve the Fed’s 2% inflation target if wage costs (borne by all businesses) continue to rise at a multiple of that target.

Not all signals are bullish. The bull-bear spread – a contrarian indicator highlighting the difference between investors who see the stock market going higher versus those who expect a decline – has been positive for nine consecutive weeks. This is the longest stretch since November 2021 and perhaps an indication that investors are nearing a level of euphoria. This is especially true when considering the current projected blended Q2 earnings decline for the S&P 500 Index of -5.3%.

Bullish Sentiment Getting Overextended?

Source: American Association of Individual Investors, Bloomberg, As of August 3^rd, 2023.

In addition, Fitch Ratings downgraded U.S. long-term debt from AAA to AA+ in a move that took many investors by surprise, citing the fiscal challenges created by Covid-19 stimulus and the partisanship during the debt ceiling negotiations in late May/early June. Though the timing of the downgrade is unclear in our view, the U.S. Treasury announced a ramp up in debt issuance on the same day, further signaling the government’s rising borrowing needs and contributing to a selloff in Treasuries and therefore pushing up yields.

A Mixed Bag So Far for Q2 Earnings

With Q2 earnings season underway and 84% of S&P 500 companies having reported through August 4^th, companies are on pace to log a -5.3% year-over-year decline in earnings. Interestingly, this decline was driven by only three sectors – Energy, Health Care and Materials – with the other eight sectors all posting earnings increases. If this is the actual earnings decline, it will mark the largest year-over-year drop since 2020. The number of companies reporting positive earnings surprises is above the 5-year average, but the magnitude of those surprises is below the 5-year average. It is also worth noting that despite a weaker U.S. dollar, companies with more international exposure (>50% of sales) are experiencing much larger earnings declines of -20.8% (versus companies <50% of international sales with a growth rate of +0.4%) as of July 31^st. In general, the results and forecasts coming out of S&P 500 companies have been varied and company-specific, but we have been seeing some repeating themes including:

• Consumer Resilience: Despite economic challenges, consumer spending remains stable, providing optimism for various industries
• Cost Discipline: Companies emphasizing prudent cost management alongside higher interest rates
• Artificial Intelligence: Still a bright spot for automation, though monetization and capex ramps have attracted scrutiny
• Geopolitical Constraints: Russia/Ukraine conflict and China re-opening as laggards to those exposed internationally

China’s Re-Opening: Expectations Collide with Reality

A notable weak spot that has emerged during earnings seasons is exposure to China – the world’s second largest economy which has experienced a slower-than-expected start to its re-opening in 2023.

For example, Caterpillar, a manufacturer of construction equipment, pointed to the lack of demand in China during its earnings call, stating that sales of its key machines used on construction sites is worse than the company forecasted in the previous quarter. CEO Jim Umpleby also mentioned that further weakness is expected to persist throughout remainder of the year.

Meanwhile, China has been pushing to become more consumer-focused rather than reliant on manufacturing, hence the importance of higher consumer confidence within the economy. For example, we have seen some strong headline numbers being called out by consumer discretionary companies such as Marriott, who saw RevPAR (revenue per available room) in Greater China of almost +125% year-over-year in Q2, we must consider the fact that the economy was shut down a year ago and it is very likely that the comparative base is lower.

The re-opening of China’s economy has been in the headlines for some time, as the country emerged from rigorous lockdown and quarantine restrictions much later than other major economies. For reference, U.S. Covid-related travel bans were lifted in late 2021 while China’s came almost a full year later. When restrictions began to lift at the end of 2022, the MSCI China Net Total Return Index¹ returned over 36% in the last two months of the year largely driven by optimistic re-opening expectations. However, the ongoing recovery has not been as strong as anticipated.

China has been dealing with lower levels of consumer confidence that stem from its housing market issues, namely the credit crisis sparked by the Evergrande default at the end of 2021. As a result, home sales have continued to underwhelm, and its citizens are seeing their property values – typically their largest financial asset – decrease. Though the Chinese government has enacted measures to aid, home sales continued to struggle in July, declining 33.1% year-over-year.

Additionally, China’s Q2 GDP growth was very weak at -3.2% annualized quarter-over-quarter. This negative print came alongside a record high level of youth unemployment and sluggish retail sales growth. The Chinese government has stepped in, enacting monetary policy to potentially boost spending on consumer goods, encourage investment in private companies, and provide businesses with access to funding. These measures also include a push to remove government restrictions on consumption such as car purchase limits. The People’s Bank of China – which cut its policy rate in June – also adjusted rules in July to allow companies to borrow more overseas.

While it is unclear if the government’s intervention will be enough to stimulate growth in China, in the context of a global equity allocation, we believe that investors should not ignore the world’s second largest economy and a major market for many U.S.-based companies. Unlike many other countries who do not have the latitude to do so, we believe China’s lower levels of inflation will allow their policy makers to be more proactive in helping to prop up their economy, a willingness they have demonstrated in the past when faced with slowing economic growth. We continue to highlight size, style and regional diversification within the equity sleeve and recommend maintaining diversified emerging market equity exposure by leveraging the expertise of active managers who can help navigate in a complex and fast-moving environment

“Weak China” Hit Rates Among S&P 500 Companies Earnings Transcripts

Source: Bloomberg, As of July 31, 2023. The transcript study leverage’s Bloomberg’s proprietary NLP to count the number of times “Weak China” and related phrases are mentioned in S&P 500 earnings calls

Portfolio Implications

Equities were broadly positive in July, led by emerging markets and domestic small caps. We have moved to a market weight on equities as part of a general shift to neutralize our positioning by moving clients closer to their long-term strategic asset allocations given ongoing economic uncertainty. Within equities, we still favor lower-beta, higher-quality names with a neutral view on value versus growth. In this more challenging environment, we would also look to active management in order to select companies with high earnings visibility.

Fixed income continued upward, with the exception of longer-dated corporates. We continue to have a favorable view of non-Treasury fixed income (credit), maintaining an overweight view on investment grade securities. While there is still time to capitalize on higher short-term interest rates, clients should consider locking in higher yields at longer maturities. We recently downgraded high yield to balance risk in portfolios, as well as in view of recent spread-tightening that has reduced the asset class’s risk-adjusted return potential. Meanwhile, emerging markets debt remains overweight given attractive relative yields and the potential to benefit from stable fundamentals, a more mature monetary cycle and stimulus in China.

Within private markets, we continue to favor private debt following the emergence of banking system stresses, as tighter financial conditions are beginning to generate opportunities for providers of liquidity. In a challenged fundraising, exit, and financing environment, significant opportunities exist for firms and strategies that can act as a liquidity and solutions provider to help close the capital supply/demand gap and support value-add transactions. This backdrop, along with NB’s deep relationships and unique position in the private equity ecosystem, has translated to record levels of deal flow across our platform. As a result, a compelling opportunity set has developed across secondaries, co-investments, private credit and capital solutions.

Index Returns

Source: Bloomberg, total returns as of July 31, 2023. S&P 500 Index is represented by S&P 500 Total Return Index. Nasdaq Composite NASDAQ-Composite Total Return Index. Dow Jones is represented by Dow Jones Industrial Average TR. Large Cap is represented by Russell 1000 Total Return Index. Mid Cap is represented by Russell Midcap Index Total Return. Small Cap is represented by Russell 2000 Total Return Index. All Cap is represented by Russell 3000 Total Return Index. Large Cap Growth is represented by Russell 1000 Growth Total Return. Large Cap Value is represented by Russell 1000 Value Index Total Return. Small Cap Growth is represented by Russell 2000 Growth Total Return. Small Cap Value is represented by Russell 2000 Value Total Return. ACWI is represented by MSCI ACWI Net Total Return USD Index. ACWI ex US is represented by MSCI ACWI ex USA Net Total Return USD Index. DM Non-U.S. Equities is represented by MSCI Daily TR Gross EAFE USD. EM Equities is represented by MSCI Daily TR Gross EM USD. Cash is represented by ICE BofA US 3-Month Treasury Bill Index. U.S. Aggregate is represented by Bloomberg US Agg Total Return Value Unhedged USD. Munis is represented by Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Munis Short Duration is represented by Bloomberg Municipal Bond: Muni Short (1-5) Total Return Unhedged USD. Munis Intermediate Duration is represented by Bloomberg Municipal Bond: Muni Intermediate (5-10) TR Unhedged USD. Investment Grade is represented by Bloomberg US Corporate Total Return Value Unhedged USD. High Yield is represented by Bloomberg US High Yield BB/B 2% Issuer Cap Total Return Index Value Unhedged USD. Short Duration is represented by Bloomberg US Agg 1-3 Year Total Return Value Unhedged USD. Long Duration is represented by Bloomberg US Agg 10+ Year Total Return Value Unhedged USD. Global Aggregate is represented by Bloomberg Global-Aggregate Total Return Index Value Unhedged USD. EMD Corporates is represented by J.P. Morgan Corporate EMBI Diversified Composite Index Level. EMD Sovereigns – USD is represented by J.P. Morgan EMBI Global Diversified Composite. Commodities is represented by Bloomberg Commodity Index Total Return. Commodities ex Energy is represented by Bloomberg ExEnergy Subindex Total Return. U.S. 10-Year Yield is represented by US Generic Govt 10 Yr.