Updated: Jul 2
The first half of 2023 was a curious beast. The NASDAQ 100 saw a powerful rally leading the index up nearly 40%. But that performance was concentrated in a small amount of stocks. Nevertheless, this was a record first half for the NASDAQ 100 and Composite, with the closest second being 2019 where the Composite rose 25.2% between January and the end of June.
The S&P 500 experienced a similarly lopsided gain so far in 2023. With mega cap tech leading the way. Breadth remains rather narrow, but more than that the leadership have stretched valuations having seen most of these gains built on the back of decelerating if not negative earnings growth.
Nevertheless, this environment of rising risk appetite within the narrative of imminent AI-driven increases in productivity and, as a result, margins has been a powerful catalyst for the market.
Whether or not that narrative proves to become a trend remains to be seen, and earnings for the rest of this year will be key to watch in order to determine if AI is living up to the promise of accelerating profits.
Futures performance in the first half was led by the NASDAQ 100, followed by feeder cattle, the Nikkei, cocoa, orange juice, and the Euro Stoxx 50. In fact, softs were some of the strongest performers in the first half, indicating that there's still potential upward pressure in key segments of food inflation.
On the other side, natural gas, S&P 500 volatility, palladium, corn, and heating oil were the biggest losers. But natural gas is starting to look interesting again as we get into peak summer heat in Texas (where the Henry Hub NG contract prices energy costs). Grid power is likely to continue to experience higher than average levels of demand, which may support natural gas along with the Freeport LNG terminal set to re-open soon.
Palladium, on the other hand, appears to be set to continue its descent unless we see a significant rise in auto manufacturing and sales.
The best performing currency in the first half of 2023 vs the dollar was the pound sterling, with the worst being the yen. With the Bank of England set to continue tightening, this outperformance may continue.
The yen is likely to continue its downward trend unless the BoJ begins to normalize their extraordinarily easy monetary policy framework. An initial sign of that may be increasing the yield curve caps so that the 10-year JGB could have a larger range. At that point I wouldn't be as tempted to fade the yen.
The biggest theme to watch in the second half of 2023 is going to be the strength (or lack thereof) of the services industry in the US. Manufacturing has been rolling over for 10 months, but services have been resilient. This week's data will be important for the US services sector, but globally services have been very resilient compared to manufacturing as well.
Because services companies are the largest source of job growth, and a tight labor market is contributing to upward wage pressure, it's reasonable to conclude that core services inflation may remain resilient unless and until we see services go into contraction.
Unfortunately such a contraction would also make a recessionary environment much more likely, but recessions are necessary to cleanse excess, and after 14 years of near-constant emergency-level monetary policy, we have a lot of excesses in this system. Thousands of zombie companies that don't make money and may not be able to survive a normalized rate environment.
We also have to contend with an overhang in commercial real estate, and especially office buildings and retail space. About $1.4T of commercial real estate debt is due to mature over the next year or so, and the refinancing may be challenging in an environment of tightening credit conditions and near record low vacancy in office buildings and challenging business conditions for retail. Though multi-family buildings may fare well in comparison.
Shifting back to the conversation about inflation, we tend to see global consumer prices led lower by global PMI selling prices with a five month lag. We are seeing global PMI selling prices fall, which is a positive sign. The question becomes whether the services industry softens enough to really provide the relief we need in core services inflation.
Consumer spending has been stronger than what I would have expected for the first quarter of 2023, and the strongest level of spending that we've seen since the second quarter of 2021. While this is a good sign for the overall US economy, it does mean that the war against inflation remains a difficult one to win with demand remaining resilient.
Most of the spending within Q1 GDP was within the services industry. Further illustrating how critical for overall inflation and demand destruction to see the services industry soften meaningfully in the months ahead.
The meaningful departure between manufacturers and services providers insofar as selling prices paints the same picture. Until services go into contraction it's unlikely that inflationary pressure fades in a meaningful way.