At Grey Ledge Advisors, we’re always keeping our eye on the markets as well as the trends affecting the investment landscape. In this blog, we’ll take a look at the market’s recent performance, ongoing debates over the fiduciary standard and socially conscious investing, the role of AI in financial advising, and how young workers are saving for retirement.

Market update

Recent market performance generated some troubling headlines, including a single-day drop in the Dow of more than 1,000 points and the S&P 500 posting its worst day in two years. This downturn occurred during a tumultuous week as investors reacted to economic data that was significantly weaker than anticipated.

Non-farm payrolls in July grew by just 114,000, falling well short of the expected 185,000, while unemployment rose to 4.3%, its highest level since October 2021, sparking fears of a recession. The Bank of Japan unexpectedly increased its interest rate by 0.25%, which shocked the markets and triggered a steep decline, with losses of 5.2% and 12.2% in a single day. The Nasdaq and S&P 500 also fell by more than 3% each. 

However, after a week, the market regained its footing with positive economic data and lower weekly jobless numbers, recovering all the losses. The unwinding of the yen carry trade, where traders and hedge funds borrow in the cheaper yen and invest in dollars, caused the initial panic. Investors should brace for upcoming election-related volatility as candidates unveil their policies and more economic data reveals the state of the economy, setting expectations for 2025.The Federal Reserve may implement interest rate cuts if the job market weakens as expected by the central bank.

Despite these fluctuations, this performance remains within the parameters of a normal market correction, which helps temper overenthusiasm about certain investments, brings stock prices back to more realistic values, and reduces the risk of bubbles forming in specific sectors. Looking at long-term trends, all major indexes have been trending positively. 

The Dow is up about 12 percent year-over-year and 4.7 percent year-to-date. The S&P 500 has grown nearly 20 percent year-over-year and 14 percent year-to-date, with the Nasdaq showing a similar trend.

Debate continues on fiduciary standard update 

Financial advisors have long been legally required to follow the fiduciary standard, which stipulates that they must act in the best interests of their clients and avoid conflicts of interests. This requirement was set with the Investment Advisers Act of 1940, while the Employee Retirement Income Security Act (ERISA) of 1974 established similar fiduciary responsibilities to parties exercising control or influence over the assets of a retirement plan.

Earlier this year, the U.S. Department of Labor released a new rule expanding the definition of which professionals qualify as fiduciaries under ERISA. The department said there are a “plethora of investment professionals” who are currently exempt from the law’s protections, and that the expanded rule aims to have these parties follow the fiduciary standard as well.

Although the rule was set to go into effect on September 23rd, it was challenged by certain groups (including insurance brokers) who claim it exceeds the Department of Labor’s authority and would create excessive compliance requirements. The U.S. District Court for Northern Texas recently stopped implementation of the rule, and the Department of Labor is likely to appeal.

While this matter works its way through the court, the current ERISA rules will remain in effect. Grey Ledge Advisors is a fiduciary under ERISA, and its advisors act in the best interest of their clients.

ESG “tiebreaker” rule back in the courts 

An investment strategy that has developed political overtones is also back in the courts. Following the Supreme Court’s decision to scrap the Chevron deference, a U.S. appeals court ordered a Texas judge to reconsider his opinion upholding a rule from the Biden administration on environmentally and socially conscious investment strategies.

The rule, established in February 2023, allows 401(k)s and other investment plans to take environmental, social, and corporate governance (ESG) considerations into account when choosing between two or more similar investment options. This rule has been challenged by the oil company Liberty Energy as well as 25 Republican-led states.

ESG investing has gained popularity as a way for people to consider factors such as a company’s labor practices, transparency, and commitment to environmental sustainability when choosing where to invest their assets. This allows investors to support companies that share their values, though it also has certain drawbacks such as a more limited pool of investment options and the potential to miss out on investments that post substantial gains. The trend has also inspired a wave of state-level legislation either supporting or blocking ESG in public investments

In another recent court decision regarding ESG investments, a federal judge in Missouri recently struck down a state law that would have required financial advisors to disclose whether they were taking ESG factors into account and obtain consent from their clients in order to do so. Opponents of the law argued that this was unnecessary since financial advisors already follow the fiduciary standard in considering the best investment options for their clients.

The growing role of AI in wealth management

During the writing of this blog, we asked an artificial intelligence (AI) platform if it had any investment advice based on current trends. It returned a few paragraphs of general advice, encouraging us to diversify our portfolio, consider long-term investments…and to go talk with a flesh-and-blood financial advisor.

It’s clear that AI still has room for improvement. There are a growing number of robo-advisor options that will set up and periodically rebalance portfolios based on information a person provides when setting up their account, and consumers often find this to be a convenient way to invest. However, robo-advisors also have a more constricted range of investment options, struggle to keep up with volatile market conditions, and generally fail to connect meaningfully with human social behavior.

Many industries have been alarmed at the growth of AI and its potential to supplant human jobs, only to find that it is better to implement AI as a supportive tool rather than a replacement one. AI has been a useful way for financial advisors to streamline certain services and dedicate more time to creating customized portfolios that meet the changing circumstances, ambitions, and concerns of clients.

Gen Z gets a jump on retirement planning

Now that Millennials are careening into middle age and Gen Z is entering the workforce, it’s their turn to be on the receiving end of criticism from older generations about their spending habits. But hold that barb about avocado toast…several studies are showing that these young adults are quite budget conscious.

MSN recently wrote about Gen Z workers who have been making a strong effort to put aside a substantial portion of their income early in their careers to start a foundation for their retirement savings. A study by the British bank NatWest also found that 69 percent of Gen Z respondents in a recent survey had created a budget to manage their finances, compared to just 42 percent of Baby Boomers.

The wide availability of retirement savings plans has also been beneficial to younger workers. A recent report by the Morningstar Center for Retirement and Policy Studies found that Gen X and Baby Boomers are most likely to be affected by employers’ move away from defined benefit pension plans, and estimated that 52 percent of Baby Boomers and 47 percent of Gen Xers may experience retirement insecurity. 

By contrast, Millennials and Gen Z are more familiar with today’s more common defined contribution plans like 401(k)s, and have also been able to benefit from features such as auto-enrollment and auto-escalation. Morningstar estimates that a lower share of the younger generations (44 percent of Millennials and 37 percent of Gen Z) may face retirement insecurity.

By Brant Walker, Chief Investment Strategist

“Now is always the hardest time to invest, especially when the market is exhibiting schizophrenic behavior.” 

This statement could apply to virtually any period in the last three-and-a-half years, starting with the impact of the COVID-19 pandemic and its associated disruptions. Before we take a look at the first half of 2023, it will be useful to review the market trends that have characterized this uncertain period and what they mean for current and forward-looking investing climates.

How we got here

The year 2020 started on a high note, with the S&P 500 index closing 2019 with a stellar total return of 28.9%. Then the potential gravity of the coronavirus became clear in February 2020. In five short weeks, the S&P lost 33 percent of its value, bottoming out on March 16th.

Around that time, the federal government began rapidly printing money to buttress businesses that had to shut down and employees that were ordered to stay home, many of whom lost their jobs. This infusion of cash buoyed the market, and stocks finished the year up 16.3%. 

The year 2021 was also an excellent time for stocks due to continued money creation and the wide distribution of COVID-19 vaccines, which helped restore a sense of normalcy and optimism. The S&P 500 index again finished strong, with a 27% gain for the year.

The following year, reality set in. The elevated money creation of the previous two years led to excess demand, driving inflation to a 40 year high of over 9%. The Federal Reserve reacted, perhaps belatedly, by raising interest rates from zero to where they stand today, at just over 5%. The stock market acted as it often does in a period of sharply rising rates and dropped, tumbling 19.5%. 

2023 so far

After a brief but steep stock market loss in early 2020, followed by two years of strong returns, and another significant downturn in 2022, where are we today after the first two quarters of 2023? To date, the market has done another about face by returning close to 15 percent. Schizophrenic indeed.

We are dealing with an unusual combination of data points that will need to be carefully monitored and addressed as 2023 unfolds. First, the yield curve has been inverted for well over a year, meaning short-term interest rates (think money market funds and bank CDs) are higher than longer term interest rates. In normal times it would be the other way around. 

Money funds now pay close to 5% and some short-term CD’s can be had for 5.5%. Long maturity U.S. Treasury bonds are yielding under 4%. This is due to the Federal Reserve trying to slow the economy and raise unemployment to get inflation back down to the 2% range. 

Despite this effort, the economy remains resilient. The national unemployment rate is near a 40-year low, and inflation remains stubbornly above 2%. Fiscal policy in Washington is also hampering the Federal Reserve’s intention of lowering inflation, as government spending and new social programs continue to pour money into the system. 

It may take more time than anticipated to get inflation down to target, and this is a risk to the markets — both stock and fixed income. Hence, we are approaching the second half of 2023 in a cautious stance.

The impact of AI

We also feel it is worthwhile to spend a few moments on artificial intelligence (AI). Some say the growing capabilities of AI have the potential to change the world, similar to the invention of electricity and the automobile. Time will tell, but we do know that a handful of technology stocks that are on the forefront of AI have appreciated rapidly due to current hype and their possible future potential. 

The situation is similar to market behavior in 1999, when the internet was still in its infancy. Anything labeled internet, and any company that had .com attached to its name, soared in value. There’s a reason this trend was referred to as the “dot com bubble,” though. In March of 2000, the highly touted tech stocks came back to earth. Some took years or decades to recover to their 1999 highs. Some have never recovered.

The bubble also allowed a handful of companies to dominate the tech sector and drive the majority of market returns. A similar trend is happening today, with six stocks accounting for most of the year-to-date market return in the S&P 500. We don’t know exactly how the AI cycle will play itself out. History doesn’t always repeat,but it often rhymes.

Year-over-year market changes

The benchmark S&P 500 stock index has returned 19.6% for the year ending June 30, 2023. The benchmark iShares Core US Aggregate bond index ended the same period in negative territory, logging a -3.5% return. These returns are in stark contrast to calendar year 2022, when the S&P 500 logged a negative total return of 18.1% and the iShares Aggregate bond index lost 14.6%. 

Usually, one would expect bonds to act as a buffer when stocks fell as much as they did in 2022. In calendar year 2022, both stock and bond markets began, in retrospect, at levels that would prove to be highs for the year. Both markets plummeted in sawtooth fashion before reaching their lows on or around November 1. 

This was caused by the Federal Reserve lifting short-term interest rates from essentially zero to the 5% level that is prevailing today.  Early in 2022 most market participants expected interest rates to stay near zero or increase on a much slower trajectory than what has actually happened, causing stocks and bonds to plummet. 

Stocks have staged a strong recovery since last November as the market has become more comfortable with interest rates at 5% and the economy remains resilient. In addition, the labor market remains strong, and the unemployment rate sits near historic lows.

Economists have been predicting an economic recession for the better part of a year based on the “inverted” yield curve, where short-term interest rates are higher than long-term rates. Inverted yield curves often presage economic recessions as the Fed attempts to slow economic activity and cool inflation. Some market pundits have quipped that this is the most widely predicted recession that never happened, at least up until now.

Year-end forecast and expectations

Market performance in the back half of 2023 depends on several variables which are yet to unfold. The first and most prominent factor will be how far the Fed increases its interest rates before the economy and inflation cool to acceptable levels. Recent reports show the economy remains resilient, inflation is still too high, and job creation has been surprisingly strong. 

Elevated government spending based on recent bills passed in Washington is complicating the Fed’s action to slow the economy. Common stocks are highly valued based on historical standards, particularly with short-term interest rates above 5% and potentially headed for 6%. 

We may have to “thread the needle” in the back half of 2023 for the markets to remain resilient. Meaning inflation, the economy, and the labor market will need to cool without triggering a deep recession. We suspect the second half of 2023 may be more challenging than the first half.