Weekly Investment Update (08/25/2023)

This Week’s Views and Positioning

The thread that connects this week’s update is interest rates. Perhaps not surprisingly, interest rates continue to be the market’s primary focus, serving as a key input into the likely path of economic growth and, most importantly, corporate earnings. In the short term, investors will continue to monitor the delicate balance between economic growth and inflation expectations, with the recent market swoon reflecting both variables. In recent months, investors became comfortable with the narrative that an economic soft landing would be achieved. Today, they are battling with how a string of above-consensus economic data may impact interest rates and, subsequently, stock market valuations. We continue to believe the economy will avoid a severe recession, but at the same time, growth will likely slow further from its current pace. In our view, this means downward pressure on interest rates, investors paying a premium for companies that can maintain solid levels of earnings growth, and a focus on security selection within industries that could face headwinds. Below, we discuss each of these key elements while highlighting implications for markets and Bessemer portfolios.

Yields Move Higher as U.S. Economic Growth Shows Resilience

What is happening: Interest rates have moved higher in recent weeks with the 10-year yield reaching a 16-year high of 4.36% before modestly retreating to 4.24%. While large Treasury issuance, a U.S. debt downgrade, and the Bank of Japan’s adjustment to its yield curve control policy have been credited for some of the yield move, the recent rise in yields also reflects a better-than-expected economic landscape. A string of economic data releases that revealed robust growth led investors to price in an increased probability that the Federal Reserve will hold rates higher for longer to prevent a reacceleration in inflation.

Why it matters: In evaluating the potential impact of changing yields on the equity market, while the movement of rates matters, we believe that the driver of the rate move is ultimately most important. To the extent a materially weaker labor market drives interest rates lower, indicative of a deteriorating economy, equity markets could struggle as earnings growth slows. However, if yields move lower on the back of further disinflation while the labor market remains resilient, risk assets would likely benefit. To be sure, this remains a delicate balance for the equity markets — if economic growth is too slow, we would likely see a negative impact on earnings. Whereas if growth is too strong, the Fed may be encouraged to keep monetary policy tighter for longer. Looking ahead, we expect slowing economic growth and disinflation to push rates lower over the coming quarters. With inflation and growth set to slow, fixed income portfolio managers have favored positioning that is longer duration relative to respective benchmarks. Historically, the 10+ year Treasury index has gained 14.5% in the year following the last fed funds rate hike. Equity exposures still focus on areas of the market that have historically been more resilient during periods of slowing growth, including underweights to the most cyclically sensitive sectors.

NVIDIA Beats Earnings Estimates as the S&P 500 Rally Stalls

What is happening: The rally in the S&P 500 year-to-date has been primarily driven by the largest companies in the index, which includes big-tech companies such as Microsoft, Alphabet, and NVIDIA. Year-to-date, these companies have benefited from artificial intelligence tailwinds and the presumed end of the Federal Reserve hiking cycle. NVIDIA’s strong earnings this week continued to provide some support for a market that appears to be losing momentum, though NVIDIA’s subsequent stock performance was underwhelming despite the strong report.

Why it matters: As mentioned in the previous section, there is a risk that the increase in interest rates over the past year increasingly weighs on economic growth and corporate earnings. Finding companies that can maintain earnings growth via exposure to strong secular trends is critical as we navigate this stage of the business cycle. NVIDIA reported earnings this week, beating both revenue and earnings estimates, and guided toward higher revenue in the coming quarter as artificial intelligence (AI) tailwinds provide continued demand for the company’s offerings. During NVIDIA’s investor call, CEO Jensen Huang noted that “accelerated computing and generative AI are driving a broad-based computer industry platform shift” as demand to build AI products remains strong. Bessemer’s All Equity Model Portfolio maintains overweight positions in NVIDIA, Microsoft, and Alphabet relative to the benchmark. Bessemer’s portfolio managers believe that the companies mentioned above have significant competitive moats, leadership positions in promising business spaces, and strong management teams.

Pockets of Housing Show Resilience, but Overall Activity Remains Challenged

What is happening: Certain interest-rate sensitive sectors within the U.S. economy have shown unexpected resilience. Newly constructed home sales and housing starts came in stronger than consensus expectations for July as homebuilders work through their construction backlogs. Tight housing supply and continued demand for new homes as millennials reach prime home-buying age have helped benefit homebuilders year-to-date, a reversal from the sharp sell-off witnessed last year as interest rates rose. While there is positive momentum on the new home front, existing home sales continue to see pressure with supply still tight as many homeowners are locked in record low mortgage rates and are not incentivized to put their homes on the market. Additionally, elevated mortgage rates are suppressing buyer activity; mortgage rates rose to the highest level in two decades this week (7.62% for the 30-Year Fixed National Average per Bankrate), pushing home purchase applications to their lowest since 1995.

Why it matters: Though the housing sector has shown some resilience thus far, affordability constraints and elevated mortgage rates are likely to continue to limit activity within the sector. Bessemer portfolio managers maintain exposure to housing-related companies with an emphasis on businesses with sustainable competitive advantages during various economic environments. Despite some of the challenges mentioned above, Bessemer holding Lowe’s Companies Inc. was able to beat earnings estimates as a result of management’s disciplined inventory, supply chain, and merchandising operations. The company remains bullish on the mid- to long-term view of the home-improvement market despite slowing housing market activity. Homeowners who are locked into their current homes due to the spike in mortgage rates could be a long-term driver of home improvement demand as they look to fix rather than buy new.