What We Think

As the nation celebrates its independence this week, many investors are celebrating a steady economy, durable earnings growth, and surging tech stocks, as seen in the 15% return on the S&P500 in the first half. However, some investors are questioning the stability of these market drivers, evoking an image of a tightrope and the possibility of a sudden fall.

On the other hand, more bullish investors may see markets traversing a balance beam, with reduced risks and greater poise. This quarterly letter will walk through these scenarios as we review current market dynamics and look ahead to the second half.

Overheating or recession?

Jay Powell and the Federal Reserve have thus far orchestrated a soft landing for the economy with inflation fading from red hot levels two years ago and employment remaining strong. Still, we could see surprises that knock the economy off balance.

Pressure at the lower end of the income spectrum continues to build with retail and consumer product companies noting that recent price inflation is squeezing consumers. Additionally, the economy could falter if the Fed anchors to fighting inflation and keeps interest rates higher for longer. In this scenario, we could be at greater risk of job losses and, eventually, a recession. The probability of this type of policy error is low, but we will be watching for any signs of this scenario.

Sure-footed corporate profits

Even as the Fed maintains high interest rates to defeat inflation, we see greater stability for the economy. Many companies and homeowners have locked in low rates, while low unemployment is driving steady incomes across a large swath of the economy.

With a stable economy, falling inflation, and plenty of consumption, big companies are reporting rising sales and profits. While many consumers are griping over high prices, many companies have found a way to adapt and sell products and services without triggering a price war that could sacrifice profit margins.

At this point, we see the “balance beam” scenario playing out. However, worsening consumer sentiment could eventually lead to an erosion of corporate profits. Any unexpected supply shocks such as higher gas prices (or simply consumer fatigue after years of inflation) could lead to lower retail spending and slower profit growth.

Investors will get a read on the stability of corporate profits when companies report Q2 results in early July. We have seen a pattern of companies exceeding investor expectations this year, especially in the technology and communication services sectors; a continuation of this favorable trend may support broader markets.

A trickier setup for the tech sector

While the economy and corporate earnings may benefit from greater stability at this point in the cycle, we see tech stocks as facing more of a tightrope situation. Booming demand for artificial intelligence (AI) software and related semiconductors is adding another layer of growth to mega cap tech companies, boosting sentiment and stock prices. However, we see downside risk in two areas.

Any unexpected slowdown in capital spending on AI chips and data centers could set off a wave of earnings misses. While most evidence points to stable or accelerating demand for AI products, we could see volatility for this part of the tech sector.

A second risk factor for tech stocks is rising investor expectations. Measures of investor sentiment such as price to earnings (PE) ratios are well above average for the tech sector, suggesting more pronounced volatility if we see any downside surprises.

How are we positioning?

Whether tech stocks are walking a tightrope or a balance beam, we take a long-term approach to owning high quality tech companies with diversified business models that are gaining market share and boosting profit margins. We take a similar approach across the portfolio and prefer to own companies with improving fundamentals through the business cycle.

As broader equity markets continue to perform well, we favor a gradual rebalancing back into bonds, where we see current interest rates as attractive for U.S. Treasuries and corporates. High- quality fixed income securities such as these have strong credit ratings and offer opportunities to lock in yields—likely well above inflation for the next five to ten years.

As we enter the second half of the year, we see greater stability for the economy and for corporate profits, though we will be closely monitoring next steps for the tech sector (which may require a bit more finesse). Still, we continue to favor a fully invested posture for both equities and fixed income, while continuously seeking companies that meet or exceed investor expectations, ever mindful of your long-term goals and objectives.

We wish you a happy Fourth of July and all the best this summer.

Michael Bailey, CFA
Director of Research

Michael Mussio, CFA, CFP®
President

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