First half of 2023 is done and dusted and what a six months it has been. Most investors came into 2023 positioned for higher volatility, wider credit spreads and economic headwinds. With many expecting an earnings and economic recession by Q223. Clearly, that is not how things have played out. While we will probably see four straight quarters of negative earnings growth, this has not been enough to offset a strong consumer and easing financial conditions. Solid progress has been made on inflation and, while economic growth continues to decline, the rate of change of that decline is much less than anticipated. Not even a hawkish Fed or tightening banking environment has been able to derail the risk on rallies in the markets. The S&P 500 had its best first half since 2019 while the Nasdaq 100 posted its best first half ever!
In short, the first half of 2023 has illustrated why we are not in a typical economic cycle. Excessive stimulus measures on the back of the pandemic created record savings for the US consumer. And it has taken longer than expected for the savings to be spent. As a result, the sensitivity of rising interest rates to the economic data has decreased significantly, which has resulted in a more resilient economy driven by consumer spending. This has kept the soft-landing dream alive and has catalyzed a surprising rally in the equity and fixed income markets.
Figure 1: Easing Financial Conditions have been a catalyst to the markets
As the 2nd quarter began, the equity markets fed off the momentum created in Q1 and markets were led higher by the same sectors. Investors gained confidence as the US Government and Federal Reserve stepped in to restore confidence in the banking system. This resulted in easing financial conditions which investors interpreted as a green light for risk assets. Better than expected Q1 earnings results, declining inflation data, constructive growth data and a surge in AI euphoria, gave investors hope that a soft landing could be achieved. We saw a broad risk on rally across all asset classes: VIX -27%, S&P 500 +8.3%, Nasdaq +12.8% and High Yield credit spreads 65bp tighter. Not even a significant increase in the yield curve could derail the rally--2yr rate +87bp or 21.6%. Large cap technology was clearly the big winner as they rode the cyclical/growth bid to new highs. Investors rotated out of cash and defensive sectors and into growth sectors as “FOMO” fears kicked in. As a result, the three “growthy” sectors (Technology, Consumer Discretionary, Communication Services) were the best performing sectors and outperformed the overall index returns.
Figure 2: Q2 Sector Performance for S&P 500
As the chart above illustrates, not all sectors benefited from the risk on rally in Q2. The breadth of the rally was very narrow and skewed to the Magnificent 7, which makes up roughly 28% of the S&P 500. As Figure 3 illustrates, the S&P 500 outperformed the S&P 500 Equal weight by 4.8% in Q2 and 9.9% YTD. Over the last three months, 68% of stocks within the S&P 500 are underperforming the index—a clear indication of narrow breadth in the market rally.
Figure 3: S&P 500 vs S&P Equal Weight for Q223
The Q2 rally was not loved by all. The narrow nature of the rally and bearish positioning coming into the quarter left many investors behind. The quarter ended with a challenging technical backdrop as most markets are in overbought territory. Significant multiple expansion has the S&P trading at 19.3x and the Nasdaq at 31.5x, both above 10yr averages and multiples have expanded for three straight quarters. We believe the equity and credit markets seem priced for perfection, which might be an issue as the tail risks continue to grow. Whether it be inflation, economic growth, fed policy, earnings or geopolitical turmoil, we believe the markets are far from an “all clear” signal. But the unexpected rally during first half of 2023 does remind investors the importance of remaining invested throughout an entire economic cycle.
Tactical Income Strategy Q223 Review
The Tactical Income allocation process is focused on determining where we are in the economic cycle and allocating risk to the asset classes, sectors and names that will outperform from the anticipated macro tailwinds or headwinds. But sometimes the economy is not aligned with market moves and this is something we have experienced during Q223.
The Tactical Income strategy has been positioned for a slowing inflation, slowing economic growth landscape for the better part of 18 months. And while investors always contend with equity rallies during a slowing economic environment, the magnitude, narrowness, and sustainability of these rallies during 2023 has created unique challenges for the Tactical Income strategy. While the investment committee has gradually increased equity exposures, the defensive posture throughout the quarter resulted in underperformance vs the benchmark*. The investment team has been focused on constructing a portfolio that offers a defensive, low volatility experience in the face of macro headwinds and an increasing number of economic and market tail risks. But the surprising easing of financial conditions, resilient consumer and resulting narrow rally in the equity markets has created significant challenges when it comes to relative performance during the quarter.
For Q223, the Hilton Tactical Income Strategy underperformed its benchmark by 159bp gross and 171bp net. As figure 4 illustrates, much of the underperformance occurred in the second half of the quarter, when the equity markets experienced the “narrow breadth” rally, that was centered on large cap technology, and in particular, the Magnificent 7. As our investors know, this type of backdrop is extremely challenging for the Tactical Income portfolio. All securities within Tactical Income must have a yield and given that 5 of these names do not pay a dividend, we are not able to own them. And while this is something we must always contend with, extreme moves like we experienced over Q2 make it very challenging for relative performance.
Figure 4: Absolute Performance & Relative Performance vs S&P 500 for Q223
Source: Portfolio Analytics Bloomberg
For illustration purposes, Figure 5 depicts how the Tactical Income portfolio performed vs the S&P 500 EQUAL Weight. The portfolio outperformed by 18bp which hopefully helps illustrate how much the Magnificent 7 influenced relative returns vs the S&P 500.
Figure 5: Hilton Absolute Performance & Relative Performance vs S&P 500 Equal Weight for Q223
Quick rundown of Q2 Attribution:
- Average Asset Allocation during Q223: 3.9% Cash, 35.8% Equity, 60.3% Fixed Income
- Yield on the portfolio as of 06/30/2023 was 4.1%
- The Hilton Tactical Income Composite Q2 return was +1.34% gross / +1.22% net, which is -159bp and -171bp behind the benchmark return of +2.93%*.
- The Q2 underperformance was primarily a result of defensive/higher quality positioning within the portfolio and the narrow breadth rally in the equity markets. While the committee did increase allocation to equities by roughly 2% and decreased underweights to certain cyclical sectors, it was not enough to offset the significant rallies in risk assets. Underweights in Information Technology, Communication Services and Consumer Discretionary accounted for much of the performance lag for the quarter.
- Equity sector contribution to return was 1.69% which was -173bp behind the benchmark*
- The biggest sector outperformers were Industrials (+21bp) and Health Care (+16bp). The biggest sector underperformers were Information Technology (-93bp), Consumer Discretionary (-61bp) and Communication Services (-36bp). As discussed, it was these “growthy” sectors that led the “narrow breadth” rally towards the end of the quarter. And many of the top performing names were companies without dividend yields, preventing TI from allocating to them.
- Detractors to Return from non-dividend paying equities that we do not own:
- NVDA (-42bp), AMZN (-28bp), GOOGL (-22bp), META (-20bp) …which totals 122bp
- Fixed Income detracted -35bp which was +15bp ahead of the benchmark*. Most of the outperformance was due to bank loan and preferred exposure which benefitted from tightening of credit spreads.
- The average duration of the fixed income portfolio as of 6/30 is 3.7 which is roughly in-line with duration of the benchmark. Average credit rating is A+.
Quick rundown of First Half 2023 Attribution:
- Average Asset Allocation during 1H23: 4.8% Cash, 34.7% Equity, 60.5% Fixed Income
- The Hilton Tactical Income Composite 1H23 return was +3.17% gross / +2.9% net, which is -424bp and -451bp behind the benchmark return of +7.41%*.
- The 1H underperformance was primarily a result of defensive/higher quality positioning and the narrow breadth rally in the equity markets. While the committee did gradually increase allocation to equities throughout the first two quarters, it was not enough to offset the significant rallies in risk assets. Underweights in Information Technology, Communication Services and Consumer Discretionary accounted for much of the performance lag for the quarter.
Figure 6: Absolute Performance & Relative Performance vs S&P 500 for 1H23
2023 has proven to be challenging year for investors. While robust 1H equity performance has masked many of these struggles, we believe we are far from an all-clear sign to justify adding significant risk to the portfolio. We feel slowing inflation and growth will remain major themes in the coming quarters, and this creates a challenging backdrop for revenue growth and corporate margins. In addition, pockets of positive economic data continue to create issues for the Fed in its fight against inflation. We believe the tail risks in both the economy and the markets continue to grow, and the investment committee remains disciplined as we seek to provide stable returns within an uncertain economic and investment environment. We will continue to watch the economic data and the Fed closely, looking for signs of a true pivot in the economic cycle. Such a change would prove more durable and would spur significant changes in the portfolio. Until then we remain patient, and as always, vigilant.