Six questions facing US stock investors as 2023's second half nears

[June 29, 2023]  By Lewis Krauskopf

NEW YORK (Reuters) - The U.S. stock market has powered higher in the first half of this year despite numerous obstacles, from banking sector turmoil to recurring doubts about the economy's health.

With two days left in the first half, the S&P 500 is up 14% in 2023 - a rebound that surprised many analysts after equities’ brutal 2022 decline. The tech-heavy Nasdaq Composite has gained 29.9%, on track for its best first-half in 40 years.

If history is a guide, stocks’ strong start may give them a tailwind in the second half. Since 1945, the S&P 500 went on to climb an average of 8% in the second half of the year when it rose at least 10% in the first six months, according to Sam Stovall, chief investment strategist at CFRA.

Here are six key questions investors are posing as they assess the market's prospects:

WHERE’S THAT RECESSION?

The U.S. economy has proven resilient in the face of the Federal Reserve’s aggressive monetary policy tightening, so far avoiding a recession many forecasters were predicting at the start of 2023.

While a recession is now seen as a less likely scenario this year, economic concerns have not disappeared. A recession probability model run by the New York Federal Reserve based on the Treasury yield curve earlier this month projected a 71% chance of one in the next 12 months.

“The prospect of a soft-landing, at least in investors' minds, has gone from improbable early in the year to now quite possible,” analysts at UBS wrote. “Of course, this positive market scenario can evaporate quickly if inflation and jobs data disappoint.”

Some analysts also worry that estimates of corporate earnings - which are expected to rise 1.4% in 2023 for S&P 500 companies, according to Refinitiv IBES data - will need to be adjusted sharply lower if a downturn arrives.

HOW FAST WILL INFLATION FALL?

The annual rate of inflation has come down by half since hitting 40-year highs last summer yet stands well above the 2% level the Fed would like to see before it begins pulling back on monetary policy tightening. The Fed paused rate hikes this month but is expected to raise rates again in July.

Some investors view moderating inflation combined with resilient growth as a so-called Goldilocks scenario that is favorable to asset prices.

CAN THE RALLY BROADEN?

A handful of megacap names such as Apple Inc and Nvidia Corp are driving the S&P 500’s rally, creating concerns that gains may not be sustainable unless more stocks join in.

A screen displays a stock chart at a work station on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., April 6, 2022. REUTERS/Brendan McDermid

While the S&P 500 has gained 14% this year, the equal-weight version of the index -- a proxy for the average stock -- has gained just 4.2%.

The spread between the two indexes is around levels last seen during the dot-com bubble, analysts at HSBC noted in a recent report.

“A concentration of equity returns from the largest companies is very unlikely to continue indefinitely,” the bank's analyst wrote.

WHEN WILL AI BEAR FINANCIAL FRUIT?

Excitement over advances in artificial intelligence has helped push stocks higher and driven up earnings estimates. Investors will watch second-quarter results in coming weeks for clarity on how soon companies expect financial benefits to materialize.

The S&P 500 tech sector now trades at 27 times forward earnings, according to Refinitiv Datastream. That is above its average of 20.9 times earnings, though well below levels reached during the dot com bubble.

WHERE ARE THE WEAK SPOTS?

The banking sector crisis resulting from Silicon Valley Bank’s failure in March did not end up being the systemic event many had feared, yet investors remain on the lookout for other financial system vulnerabilities that are being exacerbated by the Fed’s most aggressive rate hiking cycle in decades.

One such area is commercial real estate, with concerns stemming from lingering office space vacancies from the pandemic.

CAN EQUITIES COMPETE WITH BONDS AND CASH?

Rising rates have boosted yields on fixed income assets and cash to their highest levels in decades, finally giving investors an alternative to equities. That does not appear to have hobbled stock returns so far this year, but it may dull the allure of equities going forward if rates stay elevated.

The equity risk premium -- which measures the S&P 500's earnings yield against the yield on the 10-year Treasury note -- puts stocks at around their least attractive levels in over a decade, according to Truist Advisory Services.

(Reporting by Lewis Krauskopf; Editing by Ira Iosebashvili and David Gregorio)

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