In tax-exempt bonds, the theme of inadequate supply has become all too familiar. Year-to-date, supply is 16 percent below last year’s pace. Texas continues to lead the pack in new issue volume. In July, Texas accounted for nearly one third
of all new issuance and brought to market more bonds than the second (CA) and third (NY) leading states combined. Short-term yields are undoubtedly attractive, but with the Federal Reserve nearing the end of its rate hiking campaign, we are
focusing new purchases on locking in intermediate to long term yields.
The S&P 500 Index generated a strong gain in the first half of the year. However, a closer look at the underlying constituents reveals that the market’s returns were bifurcated. The largest stocks in the Index were the drivers of the
return as the eight largest positions increased by an average of more than 80 percent. These stocks rose dramatically as they are expected to benefit from the proliferation of artificial intelligence. In contrast, many other stocks generated
modest gains or declined as evidenced by the fact that strategies utilizing equal weights for index constituents significantly underperformed the traditional capitalization-weighted indexes.
In the second half of the year, we are watching for greater symmetry in the returns of each market segment. The economy has settled into a soft landing characterized by an uneven expansion. Some industries are benefiting from strong demand while
others are in, or close to, a recession. Demand patterns will normalize over time, and in anticipation of that trend, we expect more broad participation in the market rally.
International equities also participated in the rally this year. In aggregate, returns were strong driven by good performance in European, Japanese, and Latin American markets. This year, stocks in the developed markets have outperformed those
in the emerging economies as growth in China has been lower than expected.
Looking forward, we expect international equities to follow the lead of the U.S. markets. Many of the fundamental issues are similar worldwide, including high inflation rates, restrictive central bank policies, and disparate rates of growth across
industries. However, the valuations on foreign stocks are attractive by historical standards and the forward P/E ratios are much lower than those on domestic equities. An additional tailwind may be provided by a decline in the U.S. dollar.
Commodity
Commodity prices generally declined in the first half as reflected by falling inflation rates. Prices in the energy segment declined, and gold prices increased on fears of slowing global growth, recessionary concerns, and expectations for
a peak in central bank policy rates.
Looking forward, we see a mixed picture in the near term as a slowing economy should result in lower demand and a general softening in prices. However, the extent of the declines may be tempered by ongoing supply constraints related to the
war in Ukraine and a low level of investment in production capacity for some commodities. On a longer-term basis, we remain constructive on commodities, given ongoing supply headwinds across many of these markets.
Potential opportunities & risks
Opportunities
New opportunities/new markets—The outbreak of COVID-19 presented a unique set of challenges. It also provided businesses with an opportunity to differentiate and develop new markets. According to some estimates, technology
has been pulled forward two to three years and new products and services are in high demand.
Despite a push for a return to the workplace, many people are resisting that pressure and continue to advocate for flexible work policies. The ongoing demand for remote work opportunities increases the demand for technologies that can facilitate
a world of geographically distanced employees. In addition, a shortage of labor is leading companies to invest in technology with the goal of boosting productivity, automating processes, and adapting to the lack of labor supply.
The emergence of new technologies—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change the way
we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, and cloud computing.
The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled
by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing
strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and developing economies. In the coming years, blockchain technology may become a significant disruptor
in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.
Risks
Recession—The unprecedented tightening of monetary policy since March of last year has increased the risk of a recession. The Federal Reserve has reversed course from an aggressive stimulus policy to a tightening stance
in a short period of time. Monetary policy works with a lag of about one year, so we are just beginning to feel the impact of the initial rate hikes in 2022. Accordingly, it is possible the central bank has tightened too aggressively,
resulting in a hard landing for the economy and a recession in 2024.
Inflation—Given the unparalleled amount of fiscal and monetary stimulus in previous years, the war in Ukraine, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a
shortage of labor, there is a risk that inflation may remain above the average of the last thirty years.
Rising Government Debt—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt has increased
approximately 43 percent since the end of 2019 and that trend shows no sign of reversing course. While the short-term implications of higher debt levels are manageable, the long-term implications may be substantial as rising interest costs
burden taxpayers.
Deglobalization—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority
to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a
sustained increase in geopolitical tensions, upward pressure on inflation, and a rising cost structure for some industries.
Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase,
government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.
Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring developments in the war between Russia and Ukraine
as well as relations between the West and China.
Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.
Originally posted on August 22, 2023