Midyear Market Checkup: ‘Unusual’ Stock Rally and Today’s Sticky Inflation

Also, how bonds have rebounded from history’s worst market, and what to watch for in the second half of the year.

Morningstar Jun 23, 2023

Midyear Market News: 'Unusual' Stock Rally and Today’s Sticky Inflation

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. The first half of 2023 has flipped the script. The Fed has paused interest-rate hikes. A bull market seems to have chased away the bear market. Yields on super-safe bonds have climbed. So, what should investors make of the first six months of the year? Morningstar Inc.’s Chief Markets Editor and Smart Investor Newsletter Editor Tom Lauricella is joining Investing Insights.

The Fed Holds Rates Steady

Let’s start with the Fed holding interest rates steady in June … but signaling more to come. Talk about their rationale.

Tom Lauricella: So, what we’ve seen from the Fed is what a lot of folks are calling a “skip”—that the Fed has decided to hold rates steady in June after raising rates unchecked since last March. And the thinking is that they were just simply skipping the June meeting and will raise rates again potentially in July. This is different from what people are referring to as a “pause” or a “pivot.” Lots of fun Fed-related jargon out there. The basic idea here is that the Fed needs some time to assess the effect of their interest-rate increases on the economy. The phrase we hear a lot is that monetary policy acts with a “long and variable lag.” The translation of that is: We don’t know what kind of an impact all those rate increases, that 5-percentage-point increase in the fed-funds rate, will have on the economy. They need some time to see how that will affect things. So, that’s where we are right now in terms of the Fed. And the Fed is saying they’re going to keep raising rates, just could be a lot slower pace. We’ll have to see.

Bank Failures

Hampton: Well, three banks failed in the first half of the year. How is the stress in the banking sector factoring into the Fed’s decision?

Lauricella: Well, this is an interesting situation. So, the Fed acted pretty aggressively back in March to try and staunch the bleeding related from those bank failures. We don’t seem to have seen a significant impact yet. Fed Chair Powell said it’s still too early to tell. And this kind of thing takes a while to filter through into the economy. It seems like the worst of it is over. We haven’t seen any other cracks in the banking system. So, the good news for the economy is that it doesn’t seem to be spiraling on. The unknown is to what degree will that filter through. And again, that’s part of what the Fed is trying to do here is see what kind of an impact all this has on the economy.

Jerome Powell’s Thoughts on Inflation

Hampton: What makes Fed Chair Jerome Powell believe the path to a soft landing exists in this stage of the inflation fight?

Lauricella: Yeah. Powell is pointing to one of the things that a lot of economists and investors are pointing to, which is the strength in the labor market. The jobs market has been very resilient, holding in, continuing to post big gains every month in the monthly payroll numbers. Unemployment rate is still very low. So, that’s one of the big reasons that Powell and a lot of others are saying that we might actually avoid a recession, or if we have a recession, it’s going to be shallow. It won’t be that deep. But it’s the job market that has surprised a lot of people, and it’s the jobs market that has Powell optimistic that they can slow the economy, get inflation down, but not end up in a real serious recession.

Outlook for Interest-Rate Cuts

Hampton: Interest-rate hikes could hit a dozen this cycle. What’s the outlook for interest-rate cuts?

Lauricella: Well, it depends on who you ask. If you ask the Fed, interest-rate cuts are not on the table at all this year. They’ve penciled in two more rate increases through the end of the year. Other folks, in the markets in particular, think that’s not so likely. They think that the Fed will start cutting rates before we get to the end of the year. Morningstar’s economist, Preston Caldwell, is one of those folks who thinks that the Fed will start to cut rates by the end of the year as the economy softens and inflation comes down with more interest-rate decreases next year as we get into ‘24 and ‘25. But right now, it’s still very much wait and see. As I was just saying, the economy is very strong. And to be honest, for now, inflation is still kind of sticky. So, it’s a definite TBD situation on rate cuts.

Are We in a Bull Market?

Hampton: There was a big rally in stocks to start the year. Are we in a new bull market?

Lauricella: This is probably one of the big surprises of the year is the way in which the stock market overall has posted big gains. By some people’s definitions, we’re in a new bull market. There is no official arbiter of what is a bear market or what is a bull market. It’s not like there’s a team of people who decide one or the other. We have to go by conventional definitions out there. Most people will peg a new bull market as a 20% rally from the low. We’ve passed that. Some people will say we’re not really in a bull market until we surpass the old, previous highs. We’re not there yet. We’re still a good ways away from that. So, at this point, with stocks up in double-digits this year, up more than 20% from its low, some folks are saying, “Here it is, we’re back in the bull market, the bear market is over.”

Hampton: But something unprecedented is happening under the hood of that rally. What is it, Tom?

Lauricella: The interesting thing about this rally is that it’s exceptionally narrow. Almost the entire gains in the stock market this year are due to just seven stocks. People are calling it “the magnificent seven.” Lots of other nicknames and acronyms out there. But when you strip away the performance of these seven stocks—that’s Nvidia; Tesla; Meta, the Facebook company; Apple; Amazon; Microsoft; Google/Alphabet—the market is basically flat. That’s a pretty remarkable thing for just seven stocks to be responsible for the entirety of the market’s gains this year. It’s a very, very unusual situation. We really have never seen this before.

Concentrated Stock Markets

Hampton: How have concentrated stock markets worked themselves out in the past?

Lauricella: This is the big question. Will this stock market rally broaden out, or will we be vulnerable to these seven stocks falling back if people feel that their valuations are stretched? By Morningstar standards, already two of those stocks, Nvidia and Apple, are in overvalued territory, and Meta, Amazon, Microsoft, and Tesla are fairly valued. So, at this rate, it would take those stocks pushing further into more expensive territory or for the rally to broaden out. So, when you have a market this concentrated, you’ve got the risk of it just sort of falling back if those names don’t continue on. So, it’s a little bit of a risky situation. I mean, in the end, if you own an index fund, it all pans out the same. You still earn those gains. But in terms of how well it sustains it, most people would say, you know, the market needs to broaden out for this to really continue on.

AI and the Stock Market Rally

Hampton: How does the AI boom fit into the stock market’s rally?

Lauricella: One of the big drivers of the rally has been Nvidia and semiconductor stocks in general. And what we’re seeing here is a knock-on effect from this frenzy around artificial intelligence. It’s a little bit of what people would call the “pick-and-shovel approach” to investing. You don’t necessarily try and pick the end winners, like whether Google’s AI search will be better than Microsoft’s AI search, but you’re picking the suppliers. And in this case, one of the most important elements to building out artificial intelligence are semiconductor chips. And the companies that are heavily involved in that, Nvidia is probably the biggest name, they’re out in front, and so, that’s played a big part in the rally. So, we’ve seen that. And some other chipmakers also do very well. So, this has been a big part of the excitement. It kind of helped rescue tech stocks from the doldrums after last year’s bloodletting, when these were some of the names that were hit the hardest last year.

Look Under the AI Hood

Hampton: Are there stocks that are more hype than reality when it comes to AI?

Lauricella: As with any time when you get a lot of euphoria in the market about a particular topic, you get frenzy. There’s also going to be hype in names that get lifted along with that that probably shouldn’t be joining in that rally. For example, one of the names that Morningstar analysts have identified is Palantir. This stock has surged this year. It’s the government security software company. Our analyst says the AI aspect of this is nebulous. They have always used some AI in their products, but why they would boom along to the degree that the stock has doesn’t really make sense. So, for investors, this is one of those times where you really got to look under the hood and check out the stocks and see whether they really will be a beneficiary or if they’re just being lifted by hype.

Bonds in 2023

Hampton: The bond market had a rough 2022. How are bonds performing in 2023?

Lauricella: So, 2022 was the worst bond market in history for most of the fixed-income market as the Fed jacked up interest rates so substantially and inflation surged. This year has been a different story. Bonds are doing pretty well. It depends on the type of bond, which is doing better, worse, and we’ve had some seesaw activity here. But for the most part, it’s been a good year. What’s interesting is that investors are moving back into bonds, particularly attracted by high yields. We’ve written about this a fair amount. You can get very high yields, 5%-plus, on the safest U.S. government bonds—very short-term U.S. Treasuries with no credit risk, very little interest-rate risk—and still be able to earn 5%. That was something that just two years ago—you would have literally had to buy high-yield bonds, the riskiest bonds out there to get anything north of 5%. So, the bond market’s back in better shape. This is also good news for investors’ portfolios. It means that there is some cushion potentially for bonds to act as a diversifier if and when the stock market does take a tumble. So, in general, it’s been a good year for bonds.

Bond Investors Looking for High Yields

Hampton: What’s the recommendation for bond investors looking for high yields?

Lauricella: At this point, what a lot of folks are saying is that you don’t really have to stretch into more risky bonds the way you would have. Like I was saying, before you would have to own something that took default risk or credit risk, high-yield bonds, or even riskier corners of the bond market, but you don’t have to do that anymore. And that has some interesting implications for investors. It actually means in some parts of your portfolio you can take more risk. Because if you can earn 5% on a safe investment, perhaps you can actually take a little bit more risk in something that’s unrelated, such as the stock market. So, at this point, many people do think interest rates are probably more likely to go down from here than continuing to rise substantially. So, some of the recommendations are also to move out to longer-term bonds to be able to lock in these higher yields on the assumption that a year from now yields might be a little bit lower. But right now, most people are saying—go for the safe stuff and maybe a little bit longer maturities.

Market Takeaways for 2023

Hampton: What’s a takeaway or two investors should keep in mind for the second half of 2023?

Lauricella: As we head into the second half of this year, there is still, as is often the case, some significant unknowns. The biggest question here is whether inflation is going to come down enough for the Fed. The market seems to really be expecting the Fed to be able to start to lower interest rates as we head into next year. If inflation stays high, and the Fed really does need to keep rates locked at these levels, we’ll probably need to see some adjustment in the markets. Maybe bond yields will head a little bit higher. And the stock market, this bull market, may start to run out of steam. That’s really the biggest question mark at this point—is the degree to which we start to see some more progress on inflation coming down, and everything else will really depend from there. On the equity side of things, we haven’t seen that much of a slowdown in corporate earnings. That will be something that will bear watching. One of the things we’ll be looking at is to what degree this strong labor market, companies needing to hire, pay their workers more, actually starts to cut into corporate margins. That can be a little bit of a headwind for stocks. But in the end, it’s all really going to come back to this inflation question.

Hampton: Thanks, Tom, for your time today and providing a midyear check of the markets.

Lauricella: Glad to be here. Anytime.

Hampton: Be sure to subscribe to the Smart Investor newsletter. You don’t want to miss Tom’s must-read market commentary. Thanks for checking out Investing Insights. I’m thanking lead technical producer, Scott Halver; video producer, Daryl Lannert; and senior video producer, Jake Vankersen. Subscribe to Morningstar’s YouTube channel to see new videos from our team. You can hear market trends and analyst insights from Morningstar on your Alexa devices. Say ‘Play Morningstar.’ I’m Ivanna Hampton, your host, and a senior multimedia editor at Morningstar. Take care.