MARKET RETURNS: Stocks extended their rebound through the second quarter, firmly establishing a new bull market. Regional leadership shifted from international developed markets to the United States, as the rally in foreign stocks decelerated. Gains were highly concentrated, with seven large technology companies accounting for 72% of first half returns for the S&P 500. Those stocks had fallen out of favor last year as higher interest rates diminished the perceived value of their future growth opportunities. They have since staged a dramatic recovery, driven first by management’s focus on efficiency then by public fascination with the potential of artificial intelligence. High-quality U.S. bond prices declined moderately during the quarter as intermediate-term interest rates increased, putting them on pace for an annual total return in line with coupon payments. Foreign bonds fared slightly worse due to lower yields and modest dollar appreciation. Short-term cash equivalents continued to benefit from the Fed’s campaign of interest rate increases and are now outpacing core bonds so far this year.
Big Tech is Back and AI Hype: Late last year, it seemed as if large technology companies’ extended outperformance streak had come to an end. The near decade-long tailwind from low interest rates and secular trends that had accelerated during the pandemic turned. The Fed embarked on an aggressive campaign of interest rate increases and people were enjoying the outside world again after several years of staying at home, shopping online and watching streaming services. In hindsight, it appeared management teams had over-extrapolated, over-hired, and over-spent.
With a new year and fresh tone from cost-conscious executives, investors began to reconsider these companies’ shares. Artificial intelligence boosted enthusiasm as investors were captivated by the technology’s future potential. The launch of ChatGPT captured popular imagination and sent AI-related stock prices on a tear, propelling Apple to a $3 trillion market capitalization with Microsoft close behind. Add four peers and their combined value is now larger than any country other than the U.S. and China, as shown below in the analysis from Research Affiliates and Schwab as of March 31.
While AI is likely to be a transformational force longerterm, the impact should eventually broaden beyond a handful of companies and we’d be wary of chasing shares of the apparent beneficiaries. There are many parallels to the internet era of the late 1990s and we suspect AI may be near the “peak of inflated expectations” in the representation of the Gartner hype cycle at right. The good news for stock investors is that many pockets of value remain within equities, whether value stocks, small companies, or international markets
Commercial Real Estate Woes: Several highprofile examples have raised concerns regarding the U.S. commercial real estate market, particularly in San Francisco. Vacant office buildings are expected to sell at deep discounts and hotel and shopping mall owners have defaulted on loans. Despite the headlines, there are key distinctions within commercial real estate across both geographical and sector lines. Many of the issues are peculiar to San Francisco, with prevalent remote work among technology companies and deterioration in street conditions during the pandemic. Recent cell tower data compiled by the University of Toronto School of Cities placed San Francisco’s recovery dead last among 63 North American cities with activity only 32% of pre-pandemic levels. The J.P. Morgan chart at right shows that while office has the highest vacancy rate of the four main commercial real estate sectors, vacancies for industrial properties are at an all-time low for this dataset. Other specialty sectors such as self-storage also remain in high demand. The current dislocation is likely to leave overleveraged operators in distress, eventually creating opportunities for patient investors willing to bear the associated risk.
The stock market’s spectacular rally serves as a reminder that gains can often come when least expected, supporting the case for remaining invested through market cycles. Central banks appear to be making progress in their fight against inflation without causing too much collateral damage to the economy, though signs of stress from tighter financial conditions have been emerging. The labor market in particular has been remarkably resilient, with headline unemployment historically low despite other indications that supply and demand may be coming into balance. Yet full equity index valuations and increasing appetite for risk taking argue for maintaining a degree of caution against this improving economic backdrop. We favor remaining selective within risk assets as we head into the second half of the year, while taking advantage of interest rates near the high end of the past decade’s range.
S&P 500 Index TR is a market capitalization weighted index which represents the broad market for large company U.S. stocks. Returns reflect the reinvestment of dividends.
The MSCI EAFE Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developed market stocks excluding those from the U.S. and Canada. Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.
The MSCI EM Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developing market stocks. Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.
The Bloomberg Barclays U.S. Agg Bond Index is a market capitalization weighted index which represents the broad market for taxable investment grade U.S. dollar-denominated bonds. Returns reflect the reinvestment of interest.
The US Treasury Bill Auction Avg 1-month is an index comprised of short-term U.S. government-issued investments with yields collected weekly and can be considered a proxy for cash.
Benchmarks are unmanaged and provided to represent the investment environment in existence during the time periods shown. An index is not available for direct investment, and does not reflect advisory fees, any of the costs associated with buying and selling individual securities, or any other fees, expenses, or charges. Past performance may not be indicative of future results.
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