Wait and See - 2nd Quarter - 2023

Markets breathed a sigh of relief during the second quarter as tumult in the banking sector eased, the debt ceiling circus in Washington came to a merciful end, and the Federal Reserve announced a pause in interest rate hikes. Equity prices rose while volatility, as measured by the VIX, declined markedly.

While broad equity markets moved higher, gains were almost entirely driven by the large technology companies. Outperformance may be attributed to the following circumstances:

·         The tech sector is coming off a year of significant underperformance in 2022

·         Valuation multiples contracting, however fundamentals holding up well

·         Business plans to right-size costs coming into focus

·         Renewed excitement surrounding generative AI (artificial intelligence) technology, driven by the launch of Open AI’s Chat GPT

·        The Federal Reserve’s intention to pause interest rate hikes

These factors highlight many of the themes that have brought investors back to the sector. Absent the eight largest companies (all tech related) which have driven the majority of returns, most sectors have only produced modest results. The chart below shows the impact that Apple, Microsoft, Amazon, Alphabet, Meta, Nvidia and Netflix have had on markets.  

  Source: Bloomberg LP

As an example of disproportionate returns using the Communication Sector seen above, returns from Netflix (+140%) and Meta (+75%) completely dominated returns from Disney (-8%), AT&T (-19%), Verizon (-22%).

The Fed’s first and much anticipated pause in its current interest rate hiking campaign is a meaningful event, even if it now appears to be only temporary, as the word ‘pause’ suggests. Economic data, though messy, points to weakening growth and declining inflation. The Fed’s pause may also serve as acknowledgement that adjustments to monetary policy take time, perhaps as long as nine to twelve months, to filter through the financial system. Investors have worried over this aspect of the Fed’s plan from day one, but perhaps we are finally reaching the point where most of the tightening needed to quell inflation is now behind us.

The Federal Reserve has a dual mandate: to maximize sustainable employment and to stabilize prices by maintaining long-run inflation near 2% percent annually. With unemployment at historic lows, the Fed can continue attacking inflation. We believe the Federal Funds rate can and will remain at current levels until employment conditions significantly deteriorate. For the first time in more than a decade, savers are no longer losing purchasing power. With money market funds yielding close to 5% and inflation declining toward 4%, at least on paper, there is a temporary alternative to risk investments until rates inevitably move lower again. The Fed, of course, will never roll out the ‘mission accomplished’ banner and declare an end to monetary tightening. To do so would be counterproductive to its goal and only further erode its credibility as the clear-eyed, data-dependent sentinel that financial markets and global institutions expect it to be. The Fed will leave all options on the table.

At EPIQ we are adjusting investment exposure, where appropriate, to take advantage of what we perceive to be a slow and challenging environment for growth assets. With tight labor markets and increased capital costs (higher interest rates), a greater percentage of a company’s gross profit will likely accrue to its bond and preferred stock investors. Deploying capital higher up in a company’s capital structure may provide the best risk adjusted return for the foreseeable future.

Uncertainty is one of the few constants in investing. We must acknowledge this and prevent it from driving our actions. Fear and panic are not conducive to well-reasoned decision making, and history has shown that investors with a long-term view significantly outperform short-term traders. It is a mantra worth repeating.

Thank you for reading and please reach out to continue the conversation.

EPIQ Happenings

The EPIQ Clambake returns this Fall! Stay tuned for more details to follow.

EPIQ Partners