IMG Q2 2023 Investor Letter

US Economy

We started the second quarter encouraged that the banking crisis was managed without broader economic implications and that the Federal Reserve (Fed) may be close to reaching a terminal rate for interest rates.

After holding the federal funds rate near zero during the Covid-19 pandemic, the Fed has raised the rate by a cumulative 5 percentage points since March 2022, the most rapid series of increases since the 1980s. Officials slowed their hikes this year, lifting the rate by a quarter percentage point in March, April and May. Many hoped that was the final hike, perhaps the start of a long term pause or even the possibility of rate reductions by the end of the year. Fed officials left rates unchanged in June, the first pause after lifting them at 10 straight policy meetings to combat inflation.

The result has been a period of disinflation. Unlike inflation and deflation, which refer to the direction of prices, disinflation refers to a decline in the rate of inflation. For context, the consumer price index (CPI), which measures the overall change in consumer prices, peaked at 9.1% for the year ending June 2022, the largest increase in 40 years. Since then, as rate hikes have worked their way through the economy, the CPI has retreated. This temporary slowing of the pace of price inflation, or disinflation, equates to an inflation rate that has reduced marginally over the short term. It is important to note that disinflation is different from deflation, which refers to a sustained decrease in the overall price level, often linked with unemployment and very low productivity levels.

The Fed’s job is not done, and there is still work to do on inflation. Despite rate hikes, inflation and economic activity have not slowed as much as many officials anticipated this year, and economic data throughout June continued to show signs of economic strength and stubborn inflation. The core CPI, which excludes more volatile food and energy prices, came in at 5.3% in May, well above the Federal Reserve's target of 2%. So, despite leaving rates unchanged at the June FOMC meeting, officials signaled the potential for two more rate hikes this year (totaling another 0.50%) taking the rate to a 22-year high.

When the Treasury Department reached its debt ceiling of $31.4 trillion in January, there was dissention in Congress around lifting the borrowing cap. House Speaker Kevin McCarthy and Republicans who have narrow control in the House posed that raising the debt limit be accompanied by spending cuts. Meanwhile, President Biden and Democrats who control the Senate countered that they would not negotiate or offer concessions. The Treasury implemented “extraordinary measures” to keep spending within the limit, but that would only last so long and it was expected to breach the current debt ceiling on June 1st.

An actual default could create a panic, since any perceived threat that Treasury investments are no longer safe could have profound financial and liquidity implications. A default could affect global financial markets, especially since other countries rely on the economic and political stability of U.S. debt instruments.

Fortunately, after weeks of intense negotiations (and just two days before the government was set to run out of money to pay all of its bills), legislators reached a bipartisan agreement and avoided default. The Fiscal Responsibility Act suspends the debt ceiling through January 1, 2025, pushing the issue beyond the 2024 elections, in exchange for spending cuts and reforms. An end to the debt-ceiling crisis provided some much needed relief and stability to markets.

Moreover, the banking system remains sound as strains from bank failures have eased. In the recent results of its annual “stress test” of the largest U.S. banks, the Fed concluded the banks have sufficient safeguards in place to weather a severe recession while continuing to lend to households and businesses.

Other broad signs of economic health include a strong job market and healthy consumer spending. Employers have added nearly 1.6 million jobs this year through May, unemployment remains low and new applications for unemployment benefits are near a historically low level. Retail sales rose 0.3% in May after a strong April gain. That growth reflected robust hiring and rising wages that boosted incomes in recent months, further defying recession predictions in early 2023.

Traditional Asset Class Returns Q2 2023

U.S. Stock Market Recap

Stocks continued their rally, with the S&P up 8.7% in the second quarter, boosting the year to date return to 16.9%. The technology-heavy Nasdaq Composite has risen 32.3% in 2023, on track for its best start to a year since 1983. However, much of this positive performance is due to the outsized influence of a handful of mega capitalization technology names. Through May, seven companies have been responsible for most of the S&P 500's gains this year, propelled by enthusiasm surrounding artificial intelligence (AI): Apple, Alphabet, Meta Platforms, Microsoft, NVIDIA, Amazon and Tesla.

It was not until June that the breadth of the market widened. At month end, 417 S&P 500 companies were trading higher in June and 281 are now higher for the year. All 11 S&P 500 sectors were positive in June. While Technology (+6.6%) posted healthy gains, Consumer Discretionary (+12.1%) was the best performing sector, fueled by the tight labor market and strong consumer spending. Industrials and Materials snapped back in June from back to back negative months, up 11.3% and 11.1%, respectively.

From a style perspective, growth stocks dominated the first half of the year, after markedly underperforming value stocks in 2022. Growth companies are generally expected to grow their sales and cash flows at a faster pace than the overall market. They can be young, unproven, volatile firms in innovative fields, many of which pay little to no dividend. Many of these firms operate in the Information Technology and Consumer Discretionary sectors. The Russell 1000 Growth index is up 29% year to date (after finishing 2022 down 29.1%), whereas the Russell 1000 Value index is up only 5.1% (after finishing 2022 down 7.5%).

Rather than preparing for still-higher interest rates, markets are well along in pricing an economy with lower but fairly sticky inflation, higher-for-longer rates and continued growth.

Fixed Income

To start the second quarter, corporations and investors agreed with consensus that the banking stress we witnessed with Silicon Valley Bank in the first quarter was not going to be a widespread crisis. This led to a steadying of interest rates and a boost in corporate spending. However, just as fixed income investors were starting to breathe a collective sigh of relief after a volatile first three months of the year, the calm of April quickly led way to concern over the debt ceiling deadline approaching.

Treasury Secretary, Janet Yellen, announced on May 1st that the U.S. could hit the debt ceiling as early as June 1st which would potentially lead to a shock across global financial markets. Investors began driving demand into one-month Treasury Bills to avoid having their funds invested after the June 1st date, creating a significant dispersion between the yields on the 1 and 3 month Treasury bills. Retail and corporate investors were not the only ones nervous about a debt ceiling default as U.S. municipalities (both state and local) feared it could impact their ability to finance local infrastructure projects at affordable levels. Global markets were appeased when Congress was able pass a debt limit bill at the final hour to avoid default, suspending the nation’s debt limit through January 1, 2025.

The yield on the 10-year U.S. Treasury ended the quarter at 3.84%, 37 basis points or 0.37% higher than the end of Q1. With bond yields moving inversely to prices, government fixed income securities and Inflation-Protected bonds saw negative returns. High Yield was the strongest performing sector with positive absolute returns fueled by healthy corporate balance sheets.

As we reach the 12-month mark of an inverted yield curve, where short term interest rates are higher than long term interest rates, all eyes will continue to be on the Fed with the expectation now that it may take longer than initially anticipated to slow down this monetary policy cycle. As always, we continue to maintain a disciplined portfolio management process to help mitigate future uncertainties.

Diversifying Asset Classes

Many diversifying equity asset classes posted positive returns in the second quarter, including Mid Cap, International, REITs, MLPs and Managed Futures. Still, they underperformed the S&P 500 in the quarter.

Among diversifying fixed income asset classes, Convertible bonds, Floating Rate, and High Yield bonds added significant value in the second quarter, whereas Foreign bonds and Inflation-Protected bonds underperformed the Bloomberg U.S. Government/Credit Intermediate index in the quarter.

Conclusion

Despite rate hikes and sticky inflation, we continue to see economic strength and positive returns across major asset classes through the first half of 2023. Moreover, the positive performance has begun to expand beyond the seven mega cap technology companies that drove the bulk of gains through May. Ongoing elevated inflation and uncertainty around the Fed’s future path may continue to cause volatility in the markets. We plan to help you meet your long-term financial goals in all environments and encourage you to stay the course.

Sincerely,

David B. Smith, CFA

Managing Director and Chief Investment Officer