Positive Start to 2023 Sets the Stage for an Optimistic Second Half

The first half of 2023 has witnessed a robust start to the year that sets the stage for an optimistic outlook for the second half. Despite the lingering scars from the challenges of 2022 as the U.S. Federal Reserve raised its policy rate by an aggressive 425 basis points (bps) or 4.25 percentage points to cool red-hot inflation, the market gains achieved so far in 2023 signal a promising trajectory. With a more favourable economic landscape, improved monetary policy outlook, and positive momentum, the groundwork has been laid for a potentially prosperous second half of 2023.

The positive performances in international bond and equity markets in the first half of 2023 can be attributed to several catalysts and positive momentum. Building on the rally that began in late 2022, investor sentiment has been bolstered by less aggressive Federal Reserve rate hikes in 2023. And although investors reacted negatively to underwhelming early year inflation data and the emergence of a banking crisis in the U.S. with some spill over into Europe, the markets demonstrated resilience and regained strength. This was aided by the restoration of investor confidence as the Federal Reserve's rate-hiking campaign (amounting to 500bps so far) approached its conclusion. With a recovery of approximately 16% for the benchmark S&P 500 index for the first half of this year, the U.S. stock market has significantly rebounded, signalling a renewed sense of optimism. Contrastingly, at the midway point last year, stocks were down 21% enroute to full year returns of -19%.

Additionally, the interest rate environment has been relatively stable, with longer-term rates remaining relatively flat and shorter-term rates showing moderate increases. Indeed, the benchmark U.S. 10-year treasury yield fell by a modest 3 basis points (bps) over the first half of 2023 after climbing by 236bps in 2022; while the 2-year U.S. treasury yield which is more sensitive to Fed policy rose 47bps during first half 2023, somewhat reflecting policy action by the Fed as well as additional expected tightening ahead. This balance reflects ongoing moderation in inflation and a more subdued growth outlook, which has helped alleviate market concerns. While the Federal Reserve's rate hikes are anticipated to conclude in the coming months, a meaningful decline in yields will depend on further evidence of inflation trending back towards the Fed's target of 2%.

The resilience of the U.S. economy has also been a driving force behind the strong start. Despite ongoing uncertainties, the first quarter's GDP growth (which slowed from 2.6% to 2%) exceeded expectations, primarily driven by robust household services and discretionary spending. A strong and labour market and increased personal consumption have contributed to the economy's resilience, defying first half year recession calls. However, it is important to acknowledge that economic growth will likely slow further in the second half of the year, requiring careful monitoring and adaptation to changing conditions.

As we look ahead to the second half of 2023, opportunities for growth and prosperity exist alongside potential challenges. The resurgence of technology and growth stocks, which were punished severely last year, presents potential investment opportunities, particularly in companies that have not yet experienced significant gains. However, the concentration of market gains in a few mega-cap names raises concerns about market vulnerability. Additionally, while there has been improvement in the performance of bonds this year, prices generally remain depressed relative to recent multi-year history and therefore continue to offer attractive entry points. Also, as the Fed begins to close the curtain on its rate hiking act, bond investors may consider extending duration to lock in current relatively higher yields and income for longer, with a bias towards investment grade rated bonds.

While the stage is set for an optimistic second half, it is crucial to remain cautious and vigilant. Market volatility may increase, requiring investors to monitor economic indicators, central bank policy developments, and geopolitical tensions. Diversification and a balanced investment strategy are therefore essential to navigate potential risks effectively and achieve long-term financial success.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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