As we near the halfway point of 2023, the S&P 500 continues to stand strong against a softening economic backdrop. The index heavyweights have been unfazed by concerns that the Federal Reserve might soon tip the U.S. economy into recession. Instead, they have been spurred by a slow but steady decline in the inflation rate and abundant optimism surrounding the potential benefits of artificial intelligence. The same cannot be said for index companies further down the market cap spectrum. The “average stock” has fared far worse than the index leaders, evidenced by the equal-weight S&P 500’s underperformance against the cap-weighted index by 10.6% this year. This suggests a broad degree of skepticism about the prospects for the economy. For a durable bull market to take hold, market participation must broaden.
The most significant obstacle for stocks remains a Federal Reserve bent on taming inflation. Though pricing pressure is easing, there are still pockets of stickiness that the Fed believes it needs to act on. In his testimony before Congress last week, Fed Chair Jerome Powell affirmed that more interest rate increases are likely ahead, with inflation still well above the Fed’s 2% target. Barring a shock to the economy, June's rate hike pause appears to be only temporary. With unemployment sitting near historic lows, the Fed believes there is enough cushion to push on against inflation. However, it is difficult to assess what the impact of the 500 basis points of increases over the last 15 months will ultimately have on the economy. The effects of monetary policy lag by 12-18 months, and we are just moving past the one-year mark of the first 75 bps increase last summer. Many investors wonder if we are waiting for a "ketchup bottle" moment. Raising interest rates further could be like smacking a ketchup bottle repeatedly — nothing comes out at first, and then the whole bottle suddenly empties all over your dinner.
To date, the economy has held up because consumers are working and spending. Jobless claims have ticked up and layoff announcements have increased, but by and large, the labor market remains healthy. But with rates elevated and set to move higher, companies are increasingly finding it challenging to finance their growth projects. Historically, such a tightening has led to job loss. Today, labor supply is so short that companies have been reluctant to part with workers in the face of softening demand. To avoid a recession, inflation needs to subside before this dynamic breaks down.
The bottom line is that the economic outlook remains uncertain. Rather than positioning cyclical or defensive, we continue to lean into the strength of our individual companies. We are laser focused on owning companies with strong balance sheets, excellent management teams, and sustainable dividend growth practices. With the immediate environment difficult to read, we take refuge in the historical correlation between these factors and long-term outperformance. We believe our companies can weather any bumps in the road ahead and come out stronger on the other side.
Preston May, CBE®
This report was prepared by Donaldson Capital Management, LLC, a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information in these materials are from sources Donaldson Capital Management, LLC deems reliable, however we do not attest to their accuracy.
An index is a portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance to certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Past performance is not a guarantee of future results. The mention of specific securities and sectors illustrates the application of our investment approach only and is not to be considered a recommendation by Donaldson Capital Management, LLC.
S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.