Midyear Review: Staying Focused as Markets Shift

The first half of the year has given investors plenty to process—from banking turmoil to morphing yield curves to stubborn inflation prints. Those with diversified portfolios of equities and fixed income were in a good position to benefit from both assets’ advances at the year’s midway point, a welcome turn from last year’s broad declines.

UK and US stocks began 2023 with gains, with the UK underperforming the US market by around 9%.¹ While inflation in the UK remained elevated throughout the year, inflation in the US fell to half of last year's peak, and the US Federal Reserve paused in June after a series of rate increases. Regional US banks and their holdings came under increased scrutiny in early March, and several lenders were sold to larger banks as some depositors fled. Around this time, stocks began a decline, only to resume their ascent weeks later. That rally was led by US technology stocks,² whose surge coincided with increased attention on artificial intelligence and its potential.³ Value stocks and small caps started the year with gains, but growth stocks and large caps overtook them in the second quarter.⁴ The bond market rebounded after one of its worst years in decades.⁵

UK inflation slightly retreated from last year’s four-decade high, with the 12-month rise in UK consumer prices falling to only 8.7% in May and causing the Bank of England to increase interest rates to 5% in June.⁶ In the US, the reading a year earlier was more than double that of May, which came in at 4%.⁷ Fed officials paused on raising the benchmark federal funds rate in June after more than a year of increases, but signaled they were leaning toward resuming rate increases if inflation doesn’t cool further. The rapid rise in interest rates left some regional US banks, such as Silicon Valley Bank, in precarious financial positions, resulting in three of the four largest bank failures on record (after Washington Mutual in 2008).⁸ Silicon Valley Bank ended up being sold to First Citizens Bank, and other lenders similarly found themselves with new owners.

In the United States, politicians debated the debt ceiling. After much back-and-forth, the president and Congress agreed on a deal to raise the debt limit in June, avoiding the impending possibility of a US default. Amid the discussions, stock and bond markets seemed to take the news in stride. While debt ceiling machinations can dominate headlines, the implications for investors are uncertain. The current deal imposes restraints on government spending for two years.

While the MSCI United Kingdom Index was relatively flat with a gain of 2.6% in the first half of 2023, the S&P 500⁹ Index was up 16.9% in local currency terms, bouncing back from a two-year low in October and shifting from bear-market to bull-market mode upon reaching a gain of more than 20% from the prior trough. Historically, US equity returns following sharp downturns have, on average, been positive. A broad market index tracking data from 1926–2022 in the US¹⁰ shows that stocks tended to continue to deliver positive returns even after the initial recovery from a bear market, or a decline of 20% (See Exhibit 1).

Among the strongest performers so far in 2023 have been technology stocks, recovering after a poor showing in 2022. The tech-heavy Nasdaq has risen 32.3% in local currency terms until end of June. Much of the stock market’s gain can be attributed to just a handful of companies, led by NVIDIA, which saw strong chip sales as interest in AI built.¹¹

Global stock markets also bounced back after posting their worst year since the financial crisis. Worldwide equities, as measured by the MSCI All Country World Index, rose 7.8% until end of June in GBP terms. Developed stocks, as represented by the MSCI World Index, added 8.9%, while emerging markets lagged, with the MSCI Emerging Markets Index down 0.8%. 

Recent history reminds us that emerging markets can be volatile, but they represent a meaningful piece of the investment opportunity set, accounting for more than 11% of the total global equity market¹² and providing potentially valuable diversification for an investor’s portfolio. Earlier this century, the strong performance of emerging markets in a sense offset the weaker performance of developed markets (see Exhibit 2). In recent years, though, the returns of emerging markets have lagged behind those of developed markets. But taking the long view on the opportunities emerging markets hold can be a benefit for disciplined investors.

Globally, value stocks and small caps started the year outperforming growth and large cap stocks, respectively, but underperformed across the full period.¹³ However, it’s important to keep value’s recent performance in context. Last year, value outperformed growth by the largest one-year margin since 2000. That turnaround rewarded investors who remained disciplined during the three-year slump for value that ended in June 2020. Meanwhile, large cap stocks have outpaced small caps so far in 2023. Historically, small caps and value stocks have outperformed over the long term.

Global bonds rebounded after posting their worst annual return in decades last year. Most yield curves around the globe either began to invert throughout 2023 or were already inverted at the end of 2022. For example, for more than six months, the yield on the 10-year US government bond has been lower than that of three-month bills.¹⁴

Investor enthusiasm for artificial intelligence has been cited among the key drivers for tech stocks’ recent gains.¹⁵ But what does it mean for investing? Despite the promise of AI, we believe that there’s no reason to think it offers investors predictive capabilities.

Markets also aggregate information, but they are forward-looking, reflecting investors’ best estimate of an asset’s value in relation to future expected returns. That makes the market the world’s largest information-processing machine. Its “aggregated intelligence” adjusts as new information comes in, setting prices that buyers and sellers agree are fair for millions of stocks and bonds every day. AI has been around for a while and can be expected to continue to improve. But we’ve yet to see research that says anyone can outsmart the market—not even artificial intelligence.

With six months to go, some questions appear likely to capture investors’ attention for the second half of 2023. What’s ahead for the economy in the US and elsewhere? Will the new bull market charge ahead or take a breath? How long will investor enthusiasm last for all things AI? What investors do know is that markets will continue to quickly process information as it becomes available. A long-term plan, one focused on individual goals and built on confidence in market prices, can put investors in the best place for a good experience, whatever may be in store.

Fama/French Total US Market Research Index: July 1926–present: Fama/French Total US Market Research Factor + One-Month US Treasury Bills. Source: Ken French’s data library: https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.

This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security. Named securities may be held in accounts managed by Dimensional.