Q2 2023 Market Commentary: The Jenga Market

Jenga puzzle resting on top of table

Jessica Skolnick, CFA, Director of Investments
Adam Bernstein, ESG Analyst

Macro Update

As we wrap up the first half of 2023, we are astonished by and skeptical of the relentless rally in risk assets against a backdrop of escalating risks and near catastrophes. It reminds us of a Jenga tower in the late stages of a game. The market has rallied through rapid Fed rate hikes, a worsening China slowdown, regional bank failures, the UBS takeover of Credit Suisse, rising commercial real estate (CRE) defaults and a spike in corporate bankruptcies. Think of these events as blocks in the Jenga tower. As blocks are removed from the tower and placed on the top, the players exhale a sigh of relief when, time after time, the tower remains standing. But each block adds to the fragility of the tower and the probability that next time a block is removed, the tower will topple.

The question now is which block will be the one to end the game? We are watching several key risks to market stability that have the potential to shake the exuberance out of the market over the second half of the year:

1. Monetary Policy

The June Federal Reserve FOMC meeting was the first since February 2022 without a rate hike. Chairman Jerome Powell stated that, rather than hike 25 bp, the Committee preferred to wait until July to monitor incoming data before deciding whether to hike again. Despite this seemingly dovish pause, the updated Statement of Economic Projections (SEP) painted a more hawkish picture. Expectations for year-end inflation were revised upward, the unemployment rate was revised downward, and the consensus rose to an additional two more rate hikes by year-end. The bond market finally started pricing out expectations for rate cuts in 2023 and focus shifted to the incoming data.

At first glance, the 3.0% print for June CPI1 appeared to show that the Fed is close to the end of its journey toward a 2% inflation target. However, most of this decline was driven by the volatile energy component and a large downward adjustment for health insurance costs. The latter pushed down health insurance CPI by 24.9% year-over-year and is due to reset in September. Core services CPI, which excludes energy, remained much higher than target at 6.2%. Meanwhile, Core PCE, the Fed’s preferred inflation measure, has been stuck in a 4.6% to 4.7% range for the entirety of 2023. 2 Until the Fed sees progress in Core PCE, excitement over the end of rate hikes is likely premature.

2. Commercial Real Estate

The double whammy of remote work and higher interest rates has continued to hammer the CRE market, particularly offices. Most commercial mortgages are variable-rate, interest-only and non-recourse. Rapid Fed rate hikes have resulted in much higher monthly interest payments on these loans while cash flow has declined as leases expire and are not renewed. Office building values have fallen significantly, though it is difficult to tell the magnitude of the decline since transaction volume has been low. A recent study conducted by NYU and Columbia University estimated that offices in NYC could lose 44% of their value by 2029.3

Office CMBS delinquencies have increased at the fastest six-month pace since 2000, rising from 1.6% in December to 4.5% in June.4 Rather than try to refinance at higher interest rates, lower cash flow and with a property value potentially below the loan value, it is rational for landlords with non-recourse loans to simply walk away, leaving the losses with investors, banks or other lenders. The risk of widespread losses across financial institutions and investment portfolios is reminiscent of the subprime crisis of 2008, though the magnitude of the potential for systemic risk is still unclear.

3. Consumer Finances

The Covid pandemic was a boon to consumers in the aggregate. Stimulus payments, PPP loans, forbearances and reduced expenses pushed consumer savings to record highs and caused delinquencies to plummet. But the last stimulus payments went out more than two years ago and we are seeing early signs that US consumers are starting to feel the squeeze. Despite the strength in the labor market, wage growth has not kept pace with inflation. Average hourly earnings lagged CPI every month from April 2021 to January 2023.5

Credit card and auto loan delinquencies have risen this year, particularly for younger borrowers. The NY Fed reports that 4.6% of borrowers under 30 are at least 90 days overdue on their car loan, the highest rate since 2009.6 Higher interest rates pushed the average payment on a new car loan to $800 in 2022 and one in seven new car loans had a monthly payment of over $1,000.7 Another Federal Reserve survey showed that the rejection rate for loan applicants rose to 21.8% in the 12 months ending in June, the highest level in five years.8 The resumption of student loan payments in the fall is likely to increase pressure on consumer spending, which accounts for about two-thirds of US GDP growth.

4. Corporate Bankruptcies

Another recent report from the Federal Reserve found that the share of nonfinancial firms in financial distress has risen to 37%, a level higher than what has been seen in most tightening episodes since the 1970s.9 The Deutsche Bank annual default survey, released in late May, predicted a wave of debt defaults peaking at 9% for US high yield and 11.3% for US loans by the end of 2024.10 Already, corporate bankruptcy filings are accelerating. Bankruptcy filings for the first half of 2023 were at the highest level since 2010.11

Looking ahead, the corporate outlook is likely to be challenged by higher interest expenses, potential reduced consumer demand and pushback against “greedflation”. These risks, as well as the prior three, have not been adequately priced into either the corporate bond or equity markets, and any one of them could be the block that sends the tower crashing to the floor.

Market Update

Halfway through 2023, it looks like the bear market for stocks might be over, with the S&P 500 trailing its all-time high by just 7.2%.12 Investors gained confidence from falling CPI data and stocks surged thanks to the speculative artificial intelligence (AI) trade in the second quarter, hitting levels some say are commensurate with the dawn of a new bull market. However, the bond market is portraying the opposite message as expectations grew worse regarding the Federal Reserve’s intent to raise interest rates and maintain them at higher levels for an extended period, increased default risks, and a widening yield curve inversion.

The S&P 500 returned 8.7%13 and 16.8%14 for the quarter and year, driven mostly by a handful of stocks. Growth-oriented tech giants that have some exposure to the AI value chain like Apple (+49.7%)15, Microsoft (+42.7%)16, and Nvidia (+189.5%)17, were responsible for ~45% of the S&P 500s year-to-date (YTD) performance.18 The overall market performance would have remained flat through June were it not for the returns generated by these stocks, dubbed the “Magnificent Seven”.

The Nasdaq 100 will soon be conducting a special rebalance to stay within its prospectus concentration limits because the Magnificent Seven accounted for ~55% of the total weighting for the index at quarter end. Due to this low breadth market rally, style investing has come back into vogue with growth indices substantially outperforming their value counterparts. The Russell 1000 Value index returned 5.0%19 YTD while the Russell 1000 Growth index returned 28.9%.20

International markets have largely underperformed the US this year. Developed European equities returned +14.1%21, Emerging Markets returned 5.1%22, BRIC countries returned 0.33%23, and the global ACWI index was up 14.1%24 YTD. The underperformance was driven by underweights to top performing sectors like Technology and Communication Services and the underperformance of the Consumer Discretionary sector. China is down 4.9%25 YTD off a much slower than expected post-COVID economic recovery. Nearly all crucial parts of China’s economy are underperforming, from consumer demand and manufacturing to the real estate sector.

Stock market volatility declined following the June FOMC meeting but the bond market remained unsettled and the yield curve deeply inverted. Longer duration bonds gave back some of their Q1 gains with 20+ year Treasury fund TLT down 2.4%26 in the quarter vs. short-term Treasuries which lost only 0.6%27, while the Aggregate bond index lost 0.9%.28 Low duration and lower credit quality were the fixed income trades that won in Q2, with High Yield bonds and Bank Loans returning 1.2%29 and 2.5%30 respectively.

Climate and ESG Update

This quarter we will focus on three sustainability research topics that are driving parts of our macroeconomic assumptions. The first topic is popular investment themes that have driven equity markets this year and their climate implications. The second topic focuses on the recently published bank and climate stress tests and how that effects our views on the banking industry, and the third topic speaks to how our climate research has consistently led us to more entrenched inflation expectation than the market.

1. Hot investment themes and their ESG implications

The main driver for growth in the US this year has been capacity building and investment in large scale domestic manufacturing following passage of The Infrastructure Investment and Jobs Act (IIJA), The Innovation and Competition Act (ICA), the Inflation Reduction Act (IRA), and the Creating Helpful Incentives to Produce Semiconductors (CHIPS) Act. Each of these Acts was designed to bolster U.S. competitiveness in disruptive technologies such as renewable energy, batteries, and electric vehicles (EVs), as well as semiconductors. Investment has begun to pour into these industries but rising interest rates have limited upside price action for companies in these sectors so far. The manufacturing and construction industries became catalyzed by the revolution in AI language processing models and the promise of their applications.

As of the end of Q2 ~60% of the S&P 500’s total return for this year has come from just four GICS sub-industries: Semiconductors, Technology Hardware & Storage, Systems Software, and Automobile Manufacturing.31 Of these four industries, only 4 stocks, one from each industry (Nvidia, Apple, Microsoft, and Tesla) account for ~50% of the S&P 500’s total return. These specific industries are important not only in the context of their 2023 return contributions but because they play a significant role in our country’s path to net-zero alignment and climate resilience.

Renewable energy suffers from intermittency, costs, dispatchability, storage, and raw material supply chain issues. Most of these issues can be solved with time and legislation, but one linchpin remains: the kinetic nature of the grid itself. Once energy is generated, it must be used quickly or it can be lost. There is very little capacity for energy storage built into the grid today. Energy storage technological breakthroughs, such as battery technology and advanced semiconductors, are a nexus investment, combining current energy system opportunities with a net-zero reality. “Semiconductors play a fundamental role in the development of green technologies because they harness, convert, transfer and store energy as electricity and subsequently move it through the electric grid. Semiconductors are also necessary for producing electric vehicles (EVs), charging stations, energy storage facilities, and wind turbines”.32

The semiconductor value chain is broken into three main stages. Suppliers (KLA Corp, LAM Research, Teradyne) mine and/or refine the raw materials used to manufacture semiconductors. Design companies (Nvidia, Qorvo, ARM) create schematics for chips and develop software to test and debug the chips. Manufacturing companies (Applied Materials, AMD, Broadcom) actually create the chip and its components using the raw materials and the layouts developed higher up in the chain.

The group of companies that benefit most from recent legislation are the manufacturers and designers of semiconductors, the industries that have driven this year’s S&P 500 price action. The IRA Bill provided at least $45 billion in funding for the construction of new semiconductor factories and electric vehicle/ battery supply chains.33 “The CHIPS Act doled out $50 billion to boost U.S. competitiveness in semiconductors, including $39 billion in direct spending on chip production.34 Lastly the Innovation and Competition Act (ICA) authorized $110 billion for basic and advanced technology research over a five-year period targeting artificial intelligence, semiconductors, quantum computing, advanced communications, biotechnology, and advanced energy. The Act also created a supply chain crisis-response program for these critical industries.35

2. Financial System Stress Testing

Rising interest rates, losses on commercial real estate and heightened regulatory scrutiny have all come together to reshape the US banking landscape. The seeds of our current banking predicament were sowed in 2018 when legislators and politicians relaxed core banking regulations by rolling back the Dodd-Frank protections, rules that were initially put into place following the bank bailouts of the Great Financial Crisis (GFC). Deregulation lessened the regulatory burden on banks with balance sheets of less than $250 billion. Since 2018, these smaller banks often traded at premiums when compared to their large bank counterparts because of lower capital requirements, which lead to higher growth rates.

The economic environment has definitively shifted, leaving many of these banks limping forward and in need of capital. A report put out by the Federal Reserve Bank of Kansas City noted that as of the end of Q3 2022, “722 banks had unrealized losses greater than 50% of capital, 31 had negative tangible equity.”36 Following the bank failures of March 2023, the Fed created the Bank Term Funding Program (BTFP), a temporary lending program created by the Federal Reserve to help banks meet short-term funding needs.

The Fed bank stress tests, which were released on June 28th, provided the most recent insight into the state of the banking system. In this year’s exam, the banks underwent a “severe global recession” test with unemployment surging to 10%, a 40% decline in commercial real estate values and a 38% drop in housing prices.37 The overall results of the test found that all 23 of the large U.S. banks included in the Federal Reserve’s annual stress test weathered a severe recession scenario while continuing to lend to consumers and corporations. The banks were able to maintain minimum capital levels, despite $541 billion in projected losses for the group.38

Systemic stress testing is a relatively new tool for policy makers and its scope and insights are not without criticism. In 2023, 23 banks were tested, down from 34 banks in 2022. The Fed decided in 2019 to allow banks with between $100 billion and $250 billion in assets to be tested every other year, so many of the smaller and regional banks at the heart of the crisis in March were not tested. Most real estate (CRE) loans are held by smaller banks not subject to the supervisory stress test. The banks that were tested only hold approximately 20% of office and downtown retail CRE loans. Finally, only the eight largest banks were tested for a steadily rising rate scenario.39

Like the Comprehensive Capital Analysis (CCAR) bank stress test, the Federal Reserve Board announced that six of the nation’s largest banks will participate in a pilot climate stress test analysis exercise beginning in Q1 2023 with a conclusion expected by year end. Although this is a step in the right direction, the early results have been called “implausible” demonstrating a disconnect between climate scientists, economists, model builders and the financial institutions using them. For example, an assessment of global GDP loss in a so-called “hothouse” world of 3 degrees higher temperatures did not include “impacts related to extreme weather, sea-level rise or wider societal impacts from migration or conflict”.40 As a result of such overly “benign” models, large financial institutions had reported that they would suffer minimal economic impacts if the world warmed by significantly more than 1.5 degrees higher than pre-industrial levels.41

The banking system is at a pivotal moment and we are concerned that the major tools policymakers and central banks use to assess the resilience and strength of the banking system are not robust or sophisticated enough to protect the capital markets from the nuanced risks of today. Much of the continued bull case for stocks relies on a resilient continuously lending banking system.

3. Inflation Climate Thesis

In our latest blog we talked about how the start of the most recent El Niño cycle is one factor in our Investment Committee’s higher-than-expected inflation target when compared to the market. According to Bloomberg Economics, past El Niño events have increased non-energy commodity prices 3.9% and oil prices by 3.5%. They reduced GDP growth, especially in Brazil, Australia, India, and other vulnerable countries.”42 Investors would be misguided to ignore the structural challenges facing the “peak inflation is behind us” argument. Climate change and our evolving energy needs require a transformation of our global energy system, and the inflationary spending required to enact that transition will be amplified by the inflationary impact of an El Niño. As a result, we see persistent stressors on already elevated core services inflation, shifting inflation risk to the upside.

Raw material inputs like copper, rare earth minerals, uranium and natural gas are essential to decarbonizing the world’s energy supply. The demand and prices for these materials is only going up. Commodities represent about 40% of CPI, with energy and food making up 7.5% and 14% respectively.43 Commodity prices can add significant volatility to headline CPI. Energy prices have fallen sharply from 2022 highs and have acted as the major disinflationary force responsible for most of the CPI losses in 2023. As a result, the path forward for headline inflation has a lot to do with the price of energy, which is unlikely to repeat such a significant decline.

US shale oil has been one of the primary sources of incremental supply for the past decade so the future of US fracking has significant implications on inflation. Between the steady stream of negative reserve revisions and the decline in US well performance, US shale is struggling. Without finding new wells and oil basins to tap into, the data suggests the best days of the US shale industry are behind us, no matter the price energy trades. With the threat of global oversupply minimal, thanks to the precarious US energy position, depleted strategic reserves, and continued production cuts by OPEC+, we believe the risk for energy prices is structurally to the upside.

  1. Bureau of Labor Statistics, Bloomberg, as of June 2023
  2. Bureau of Economic Analysis, Bloomberg, as of May 2023
  3. Remote Work Will Destroy 44% of NYC Office Values, The Real Deal, May 22, 2023, https://therealdeal.com/new-york/2023/05/22/remote-work-will-destroy-44-of-nyc-office-values/
  4. June 2023 Delinquency Report, Trepp, https://www.trepp.com/trepptalk/cmbs-delinquency-rate-june-2023-offices-delinquencies-increase-again
  5. Bureau of Labor Statistics, Bloomberg, as of June 2023
  6. Household Debt and Credit Report Q1 2023, Federal Reserve Bank of New York, https://www.newyorkfed.org/microeconomics/hhdc
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  8. June SCE Credit Access Survey, Federal Reserve Bank of New York, https://www.newyorkfed.org/microeconomics/sce/credit-access#/financial-fragility1
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  10. Default wave imminent, will peak in 2024, Deutsche Bank says, Reuters, May 31, 2023, https://www.reuters.com/markets/default-wave-imminent-will-peak-2024-deutsche-bank-2023-05-31
  11. 54 new US corporate bankruptcies take H1 tally to highest level since 2010, S&P Global, July 6, 2023, https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/54-new-us-corporate-bankruptcies-take-h1-tally-to-highest-level-since-2010-76444770
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  33. H.R.5376 – Inflation Reduction Act of 2022, Congress.gov. September 27th, 2021. https://www.congress.gov/bill/117th-congress/house-bill/5376/text
  34. H.R.4346 – Chips and Science Act, Congress.gov. July 1st, 2021. https://www.congress.gov/bill/117th-congress/house-bill/4346
  35. S.1260 – United States Innovation and Competition Act of 2021, Congress.gov. April 20th, 2021. https://www.congress.gov/bill/117th-congress/senate-bill/1260
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  40. Financial models on climate risk ‘implausible’, say actuaries, Financial Times. July 4th, 2023. https://www.ft.com/content/a5027391-41a4-4e21-a72d-f8189d6a7b71
  41. Financial models on climate risk ‘implausible’, say actuaries, Financial Times. July 4th, 2023. https://www.ft.com/content/a5027391-41a4-4e21-a72d-f8189d6a7b71
  42. The Return of El Nino Threatens New Economic Destruction, Bloomberg. https://www.bloomberg.com/graphics/2023-el-nino-climate-change-extreme-weather/#xj4y7vzkg
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