Looking back at the first half of this year, Fed remains firm in raising interest rates, and the US benchmark interest rate has broken through the 5% . At the same time, although global inflation has fallen, it is still far from the 2% target.
“Higher For Longer” for the interest rate has gradually been verified. The birth of ChatGPT has triggered the fantasy of artificial intelligence to greatly improve production efficiency, which is the biggest surprise in the first half of this year. Under these multiple influences, the United States may enter the era of "high interest rates, high inflation, and high growth" in an all-round way. Looking forward to the second half of the year, how will the market perform?
I. Asset Performance Review in H1
1. Major asset returns
Let's first look at the performance of major asset classes. As shown in the figure below, the economic resilience of developed countries led by the United States is stronger than expected, and they have not entered recession as many analysts said at the end of last year, which has prompted their stocks to soar all the way.
Among them, $NASDAQ 100(NDX)$ even recorded a nearly 40% increase within six months. In contrast, stock markets in Greater China were slightly weaker. Affected by the peak of interest rate hike expectations, bonds also performed well in the first half of the year, and most of the major bond assets closed positive.
In terms of currencies, Bitcoin has taken the lead, and the violent rise of the US dollar index last year ended.
At the same time, in terms of commodities, energy and industrial metals fell significantly, while gold played a good hedging property.
Source: Bloomberg and Tiger Trade Data Period: 2023/1/1-2023/6/30
2. The AI technology revolution drives the prosperity of the US stock market
The biggest surprise in the first half of the year was artificial intelligence. ChatGPT has ignited the market's enthusiasm for general AI, and an information revolution comparable to the Internet may have arrived. The semiconductor industry was the first to benefit, contributing a 3.53% increase to the S&P 500 Index. Among them, Nvidia, the leader in AI chips, rose nearly three times and successfully broke into the trillion-dollar market capitalization club.
As shown in the figure below, the three sectors of information technology, consumer discretionary and communication services have contributed a cumulative increase of 16%, accounting for more than 95% of the total increase of $S&P 500(.SPX)$ .
Not only that, among the three sectors, only $Apple(AAPL)$ , $Microsoft(MSFT)$ , $NVIDIA Corp(NVDA)$ , $Amazon.com(AMZN)$ , $Tesla Motors(TSLA)$ , $Meta Platforms, Inc.(META)$ and $Alphabet(GOOG)$ , the seven major technology giants, contributed up to 12% of the S&P 500's increase.
Source: Bloomberg and Tiger Trade; Data Period: 2023/1/1-2023/6/30
3. Major strategies’ gains
In terms of main strategies, Goldman Sachs VIP hedge fund ETF, which is purely long-term strategy for fundamental stock selection, performed well. Global 6040 and global allocation funds also benefited from the upswing in the stock market and performed well. However, the global macro strategy fund that shined last year has faded, showing The strong influence of macro factors on the market has been greatly weakened. Commodity trends and equity neutral strategies were equally mediocre.
Source: Bloomberg and Tiger Trade; Data Period: 2023/1/1-2023/6/30
II. Review of H1 2023: Outlooks vs. Realities
In the last month of last year, we made a full-year outlook on the main line of global investment and major assets in 2023.
Panning for Gold I: 2022 major global assets performances review
Panning for Gold II: US, Eurozone, China 2023 Economic Outlook
Panning for Gold III: Semiconductor & New Energy Industries Under Deglobalisation
Panning for Gold IV:2023 Outlook for US/HK/European Stock Markets &Commodities
Now half a year has passed, some of our predictions have become reality, and some of our predictions have completely failed. The emergence of ChatGPT and the crisis of small and medium-sized banks in the United States have largely changed the main line of the market, and we are also dynamically adjusting our views and allocation suggestions in the continuous market review.
1. Outlook at the beginning of the year and evolution in the first half of the year
| Outlook at the beginning of the year | Reality | Allocation suggestions we gave during the period |
US stocks | Small Caps Lead, Big Tech Stocks Weak | Big tech stocks soared❌: The emergence of ChatGPT is regarded as the first year of the explosion of AI technology, supporting large-scale technology stocks. At the same time, Apple releases XR glasses, the semiconductor industry have bottomed out, and Tesla's cost and demand are all improving. The multiple benefits has brought a wave of surge. | AI and large technology stocks contributed 3.34% of the return ✔️: Change the forecast at the beginning of the year, and increase allocation of AI -from February. |
Volatility is the main line throughout the year. U.S. stocks will rise first and then fall. For the first half of the year, the peak of interest rate hikes and China's reopening-are good for US stocks to rise | U.S. stocks rose in the first half of the year✔️: interest rate hikes gradually peaked, and the impact of interest rates on the stock market weakened | Oil and gas exploration stocks contributed 0.58% of the gains✔️: OPEC+ cut production. Oil and gas exploration stocks with low capital expenditure and high free cash flow are good investment opportunities during the stagflation period | |
Greater China | Recovery | Recovery not as expected ❌ | Greater China stocks long position contribution -1.03% return ❌ |
U.S. debt | Last hike in March to 5~5.25% | Higher and longer interest rate hikes ❌: The rate hikes are longer and higher than predicted at the beginning of the year, mainly due to the rise in real interest rates brought about by the strong economic resilience of the United States, giving the Fed room to continue raising interest rates. | Short-term bonds and money market fund contribute 1.01% of the return ✔️: Enjoy the return of risk-free assets under high interest rates. |
US Treasuries will fluctuate throughout the year, so it is not appropriate to chase ups and downs. When the 10-year treasury yield returns to above 4%, there is a good allocation safety cushion. | The 10-year treasury yield peaked at around 4% ✔️: In the first half of the year, the 10-year treasury yield reached around 4% in early March and quickly turned down. At the end of June, it rose again and hit 4%. | Long-term bonds contribute 0.85% return ✔️: Buy long-term bonds when the long-term interest rate is close to the target high of 4% at the end of February and early June. | |
Rate cut is possible if recession happens at the year-end. | The market is pricing in the possibility of a rate cut✔️: The Fed Fund futures market continued to price in the first half of the year with a high probability of rate cuts this year, and the thunderstorm at a small bank in March aroused recession concerns, and it once priced four rate cuts within the year. However, as the economic resilience continues to be confirmed, the starting point for interest rate cuts has also been postponed from the middle of the year to the end of the year. | ||
Gold and Commodities | Affected by the combination of recession expectations,inflation stickiness and geopolitical risks, gold will become the core asset in 2023. But we need to pay attention to the risk of the US economy being too strong. | Gold first strengthened and then weakened in the first half of the year⭕: The U.S. economy weakened first and then strengthened. Since May, U.S. economic data has continued to exceed expectations, and interest rate hikes have not completely stopped. The most unfavorable environment for gold has emerged, triggering a gold correction. | Gold and gold mining stocks contributed 1.58% of the return ✔️: increase gold positions after bank run, and gradually reduce their positions from May after making profits, thus reducing the impact of the fall in gold prices. |
Inflation forecasts rose and then fell ⭕: similar to the level at the end of last year. |
2. Performance review of allocation suggestions
According to the allocation suggestions of each market review in the first half of the year, we simulated and constructed an ETF portfolio without individual stocks. This portfolio aims to show the base returns of our asset allocation strategy based on macro, capital, fundamentals and technology.
As shown in the figure below, the total return rate of the portfolio in the first half of the year was 6.4%, among which AI concept stocks and large technology stocks contributed the most, and gold and gold mining stocks, oil and gas stocks, and long-term treasury bonds also contributed a lot of returns. Greater China stocks became the only negative item.
Source: Bloomberg and Tiger Trade
Going all the way according to our allocation recommendations, the first-half return was 6.37%, which is equivalent to an annualized return of 13.43%. The largest retracement of 2.78% in the portfolio occurred from late April to early May, mainly due to the negative impact brought by the continuous decline of the Greater China stocks in the holdings and corrections in oil and gas exploration stocks.
On the whole, our ETF allocation portfolio is based on the principle of low correlation and decentralized allocation, and its performance is stable and rising.
Source: Bloomberg & Tiger Trade; Data Period: 2023/1/1-2023/6/30
3. Outlook for H2: Profitability is the Key Variable
In our review article at the end of January this year, we pointed out that the key to asset allocation for the whole year would depend on whether the expectations of China's recovery and the Federal Reserve's shift would become strong realities.
However, at that time, we overlooked the possibility of the resilience of the US economy. The impressive debut of ChatGPT and Apple's Vision Pro instantly opened up the market's imagination of profit potential for large-cap tech stocks and the semiconductor industry, prompting us to reshape our thinking in response. Therefore, we will focus on the outlook for the second half of the year on the US stock market.
1. Profit expectations determine the bull sectors in US stocks
Although in the outlook at the end of last year, we underestimated the duration of interest rate hikes by the Federal Reserve. Regardless of whether the Federal Reserve will raise rates once or twice more, this round of rate hikes is nearing its end. This means that the impact of interest rates on US stocks will become less significant, and the growth and decline of profits across different industry sectors will be the core variable for US stocks going forward.
As shown in the chart below, the consensus estimates for the three major US stock indices have experienced varying degrees of decline since last year. Among them, the Nasdaq, driven by the AI concept, has already returned to its previous high in terms of consensus estimate, while the Russell 2000 index, which has a weighting of over 15% from small banks, experienced a decline of over 30% in consensus estimate since Q2 of last year, with only a slight rebound in recent times.
Source: Bloomberg
The expectations of large-scale general purpose AI models have raised the profit outlook for the technology sector.
The powerful language processing and generation capabilities of large-scale general purpose AI models, as well as their wide applicability and efficiency improvements in various scenarios and applications, have significantly raised market expectations for the profitability of large-cap tech stocks, supporting their surge in the first half of this year.
Source: Bloomberg
As we enter the second half of the year, with increased investment in AI research in the technology sector, whether their profit growth story can continue to meet the market's high expectations will be crucial to their stock performance.
Reshoring and friendshoring in the US manufacturing industry bring new sources of profit growth
Reshoring and friendshoring in the US manufacturing industry have been strategic directions pursued in recent years, aiming to reconfigure the global supply chain and bring back some production activities to the domestic or allied countries.
From the perspective of US manufacturing construction spending (orange line) shown in the chart, there has been a noticeable acceleration of this process after the COVID-19 pandemic, and the number of non-farm payroll in US manufacturing (white line) has surpassed pre-pandemic levels since the second half of last year. The hourly wage for US manufacturing workers has also increased from $31.23 in January 2020 to $36.31 in June 2023.
Source: Bloomberg
As a result, industrial sectors in the Russell 2000 index, which benefit from the increase, have shown better estimated revenue and profit performance compared to the overall Russell 2000 index since the second half of last year.
Source: Bloomberg
We believe that machine production and automation are the main directions for industrial adjustment brought about by the reshoring of US manufacturing.
This will create new profit growth point for industries related to small and mid-cap industrial sectors, such as construction, equipment leasing, mechanization-related industries, mid-to-low-end chip processing companies, factory REITs, and regional banks with healthy balance sheets that provide loans to them. Of course, industrial adjustments will inevitably bring about a new cycle of capital expenditure expansion, which is limited in a high-interest rate environment.
2. Structural shock of high interest rates on profitability
The Federal Reserve has raised rates by 500 basis points over a 14-month period. Many are concerned that the financing costs for US companies will increase significantly, affecting profitability. However, we believe that the impact of this rate hike cycle on US stock profitability will not come so quickly, and the impact on different industries will also be uneven.
US companies raised over $4.2 trillion in financing during the zero interest rate period in 2020-2021, with a majority being long-term fixed-rate bonds.
As shown in the chart below, the issuance of US corporate bonds in 2020 and 2021 exceeded any year in the past 30 years. While after entering the rate hike cycle in 2022, the issuance of US corporate bonds returned to the levels of 2018 and 2019.
Source: SIFMA, Tiger Trade
According to the statistics from Bank of America for the first quarter of this year, 76% of the debt of companies in the S&P 500 index consists of long-term fixed-rate bonds, significantly higher than the level in the fourth quarter of 2007. The interest expense on these bonds is fixed and will not be affected by the current high interest rates until maturity.
Source: Bank of America
US corporate bonds will reach a peak in maturities starting from 2024
As shown in the chart below, starting from next year, there will be over $1 trillion in US corporate bonds maturing each year. Companies are likely to need to refinance in a high-interest rate environment, leading to increased interest expenses.
Source: S&P Global
However, the issuance of corporate bonds in the first two quarters of this year was slightly higher than the same period last year, resulting in the total issuance of corporate bonds for 2022 and the first half of 2023 exceeding $2.2 trillion, surpassing the total amount of corporate bonds maturing in these two years. This, on the one hand, will increase current interest expenses for companies, but on the other hand, it also provides a certain buffer for more corporate bonds maturing in 2024.
Source: SIFMA, Tiger Trade
Compared to large-cap stocks, small-cap stocks are more affected by high interest rates
The impact of increased interest expenses on stock profitability is uneven. According to a research report by Goldman Sachs, the debt structure of companies in the Russell 2000 index shows that about 60% of their debt consists of long-term fixed-rate bonds, and 30% is floating-rate bonds that will be affected by the current high-interest rate environment.
However, the proportion of small-cap stocks' corporate bonds maturing will significantly increase starting from 2025. If the Federal Reserve maintains high interest rates by then, it will have a significant impact on the profitability of small-cap stocks. At the same time, the net leverage ratio (net debt/EBITDA) for small-cap stocks is currently 2.7 times, higher than its historical median of 2.2 times. In comparison, large-cap stocks have a net leverage ratio of only 1.7 times, slightly higher than their historical median of 1.6 times.
Source: Goldman Sachs
Furthermore, according to data from Bank of America, among the primary industries of small-cap stocks, the industrial sector and the essential consumer sector have the lowest proportion of long-term fixed-rate bonds, and thus their profitability is most affected by high interest rates. On the other hand, the energy sector has the least impact on profitability from high interest rates.
Source: Bank of America
Johannes Matschke and Sai Sattiraju, economists at the Kansas City Federal Reserve, pointed out in their June research paper that in order to bring the inflation rate down to the target level of 2%, the Federal Reserve may need to maintain benchmark interest rates above 5% until 2026.
If this turns out to be the case, companies with a lower proportion of medium to long-term fixed-rate bonds and requiring large-scale refinancing in the next two years will face a significant increase in interest expenses.
Of course, given the relatively small amount of corporate bonds maturing this year, the impact of high interest rate on the profitability of US stocks in the second half of this year is likely to be limited to regional banks directly affected by the inversion of short and long-term interest rates.
3. Low leverage in the household sector and a cooling job market will reduce the strength of the service industry
In the first half of this year, the continuous strength of the US service sector, with monthly service PMIs above the 50 threshold, indicates that the level of activity increased to varying degrees compared to the previous month. This is the main reason why the US economy exceeded the expectations of most professionals, including the Federal Reserve, despite the continued decline in the manufacturing sector. Therefore, how long the boom in the service sector can be sustained is also a key factor in determining whether the rebound in US stock profitability can be sustained.
Source: Bloomberg
We believe that the low leverage and rebound in savings in the US household sector support the current high activity level in the US service industry. As shown in the chart below, the proportion of US household interest expenses to disposable income (blue line), as reported by the Federal Reserve, is still at a low level since 1980, while household savings (white line), although significantly lower after the end of government stimulus, remained relatively high compared to the period since 1980 after rebounding in the first half of this year.
Source: Bloomberg
The strong US job market supports the growth of household wage income. According to the non-farm employment report as of May, the year-on-year growth rate of hourly wages in the US service sector is still at 4.3%, higher than the current CPI growth rate. Based on an NFIB survey of 800 small businesses, the difficulty of filling job vacancies is also at a high level since the 2008 financial crisis.
Source: Bloomberg
However, in history, the US job market has often transitioned from hot to cool relatively quickly. Since 1970, within 1-2 years after the average number of initial jobless claims (4-week moving average) reached its bottom, the US economy officially entered a recession.
As shown in the chart below, the average number of initial jobless claims in the US hit its bottom in October last year and has been slowly rising. We expect the impact of a cooling job market on the strength of the service industry to become evident from Q4 this year to Q1 next year.
Source: Bloomberg
Therefore, we believe that industries related to the service sector, such as retail, tourism and hospitality, and the financial industry, may face more headwinds towards the end of this year.
Conclusion
In conclusion, the Federal Reserve's Higher For Longer policy implies that the global economy will likely continue to endure a high-interest rate environment in the second half of this year and possibly the first half of next year. However, some stocks will still shine in this environment.
Companies with breakthrough profits brought about by technological revolution, profitability resilience brought by strong debt and cash flow structures, and profit moat brought by professional barriers will always be the preferred high-quality asset choice for large capital allocations.
Our outlook for the second half of this year mainly focuses on analyzing whether the expectations for structural profitability can be maintained; and based on current observations, whether there is a greater upside potential or downside risk. For example, the Citi Economic Surprise Index, which measures whether economic data in various countries mostly exceeds or falls short of expectations, often needs to be closely monitored when it reaches high or low levels.
Source: Bloomberg
In the process of real investment, continuously observing changes in expected core variables and the development of market, adjusting analytical frameworks, and tactically changing asset allocations are necessary and common practices. We will continue to update our views in future market review series.
Allocation recommendations: 10% money market funds + 20% US long-term government bonds + 15% US tech stocks + 15% US Oil&Gas Stocks + 15% small-cap manufacturing stocks + 20% Greater China stocks + 5% gold.
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