July 2023 Stonemark Market Commentary

Hot Rates, Cool Inflation?

The weather temperatures were not the only thing that kept rising in July. While the Central Bank's predicted interest rate hike occurred, surprising GDP and inflation figures kept equity markets searing. Second-quarter economic growth numbers exceeded expectations, leading some skeptics on Wall Street to consider the possibility of a "soft landing" for the U.S. economy — where the Federal Reserve reduces inflation to its target 2% range without causing an economic downturn. However, some remain concerned about a potential recession resulting from aggressive policy changes.

Economic Data

In July, investors with a positive outlook on the market received good news when the June CPI data showed a larger inflation decrease than anticipated. On July 12, the Bureau of Labor Statistics released the previous month's CPI and Core CPI data. Although the headline CPI increased by 0.2%, the annual rate declined to 3% year-over-year, the lowest increase since March 2021. Core CPI, which excludes the more volatile food and energy inputs and is closely monitored by equity markets, also saw a 0.2% increase, the smallest monthly rise since August 2021. The annual rate for Core CPI decreased to 4.8%, dropping below 5%, a welcome relief from numbers close to 6% seen a year ago.

However, there was an unexpected shortfall in the June nonfarm payrolls report, released on July 7, which came in at 209,000 and lower than the estimated 240,000. This helped to moderate the "animal spirits" in the market, and it was the first time since April 2022 that payrolls failed to meet expectations. Despite this, economists quickly noted that the report was still positive, highlighting the labor market's resilience, with over 200,000 jobs being created monthly since January 2021. Furthermore, the unemployment rate dropped to 3.6%, and average hourly earnings exceeded expectations by rising 0.4%.

Continuing with the economic positivity for July, second quarter real GDP for 2023 exceeded expectations. It grew at an annual rate of 2.4%, surpassing estimates of 1.5% and increasing from 2% in the First Quarter. The growth was mainly driven by consumer spending, nonresidential fixed investment, state and local government spending, private inventory investment, and federal government spending. However, the decrease in exports and residential fixed investment had a negative impact. Despite this, the July 27 report indicated that the U.S. economy is managing the fastest rate hikes in a generation without significantly harming its vital components fueling the "soft landing" narrative, as the path to avoiding a recession appears clearer.

Investors, though, should be cautious despite the recent price gains in risk assets due to an improved inflation outlook and positive sentiment. On July 20, the Conference Board released its Leading Economic Index, which measures ten components, including three financial and seven macroeconomic indicators. The index is designed to indicate early significant turning points in the business cycle and the economy's direction in the near future. In June, the LEI fell by 0.7% to 106.1, following a 0.6% revision in May. This decline was slightly higher than the median expectation of economists, who predicted a 0.6% decrease. The index saw its 15th consecutive decline in June, the longest decline since the 2007-2009 recession. The main causes of this trend are a weakening consumer outlook and an increase in unemployment claims. The contraction in the Leading Economic Index is gaining momentum, with a 4.2% decrease in the last six months, compared to a 3.8% decline between June and December 2022, according to the Conference Board.

Finally, on July 26, the Federal Reserve raised interest rates to the highest point in 22 years by 25 basis points, bringing the key rate to 5.25% - 5.50%. Although inflation has improved since the last meeting, the Fed recognizes that prices are still high and is committed to achieving economic stability. Chairman Powell stressed caution and signaled no rate cuts until Q1 2024, at the earliest. The future beyond July is still uncertain, as many economists expect another rate increase to be announced at the September 20 meeting. However, with continued cooling inflation data, the July rate hike may signify the end of the Fed's cycle of increasing rates.


The Central Bank has continued to tighten the economy in 2023, but the stock market has not been affected much due to inflation falling. Although the stock market's overall performance has been a welcomed surprise, it is important to note that the gains are concentrated in just a few companies. Dubbed the "Magnificent Seven" (Apple, Microsoft, Google, Amazon, Nvidia, Facebook, and Tesla) are responsible for more than 60% of the total gain in the S&P 500 index. If we compare the S&P 500 without these companies, we can see that they are the primary catalyst for this year's impressive performance.

It is not uncommon to come across highly concentrated markets. In 2020, the top ten stocks contributed to over one-third of the U.S. market's increase. However, this year, the concentration has doubled and is driven by a particular standout sector. Over the past six months, the use of A.I. has rapidly expanded from a specialized I.T. development tool for machine learning to a major contributor to the projected $3 trillion I.T. expenditure by the decade's end. Despite its growing popularity among investors, A.I. technology is still in its early stages. Currently, the total addressable market, which includes semiconductors, hardware, and networking, is valued at $90 billion, but it is expected to reach $275 billion by 2027, according to FactSet.

Semiconductors are driving this remarkable growth, and the market's future potential is reflected in the soaring valuations of semiconductor companies. Since the launch of OpenAi in November 2022, the Semiconductor Industry's Forward Price-to-Earnings (P/E) multiple has increased by 95%, surpassing the impressive 32% increase of the S&P 500's Forward P/E multiple.

Essentially, at 28.6x Forward P/E, investors are getting an earnings yield of 3.5% on Semiconductors while the risk-free rate set by the Fed is now above 5.25%. Due to the elevated levels of stock valuations and prices, exercising caution and carefully evaluating buying choices is crucial. Our investment framework considers three important factors. Firstly, we identify the areas along the tech supply chain with the highest revenue exposure and growth potential for A.I. Secondly, we prioritize earnings results, focusing on generating free cash flow. Finally, we assess if the present stock values properly reflect the potential for growth and the management team's leadership abilities.

Although some may compare A.I. to the dot com bust of the early 2000s, we firmly believe that the current leading A.I. companies are well-established and far from bubble metrics. These companies, such as Apple, Microsoft, Adobe, Google, ASML, and Nvidia, have solid operating characteristics and generate consistent profits. This starkly contrasts with the negative earnings companies that suffered during the dot com collapse. While A.I. is expected to be a growth driver for most, revenue growth will only be generated by some. Moreover, potential global economic cycle slowdown risks may impede this growth. Finally, investors have been blurred by recent enthusiasm and have overlooked the ethical and regulatory dilemmas associated with A.I. We will closely monitor these issues and provide updates. As always, staying informed and closely monitoring any developments that may impact your investments is important.