Tech Rebound Boosts Growth OptimismTechReboundBoostsGrowthOptimism

The health care sector of the S&P 500® Index advanced 3.0%, trailing the overall Index’s 8.7% return. Additionally, the Nasdaq Biotechnology Index declined -1.0%. Over the trailing 12 months, the health care sector’s 5.2% return trailed the overall Index’s 19.5% gain.

It’s encouraging to see the post-pandemic recovery now apparent within the health care sector. Many industries are expected to realize above-historic-trend growth, particularly for drug reviews, drug approvals, and elective procedure growth. Additionally, as merger and acquisition activity has accelerated, Washington D.C. has become more amenable to approvals. Should economic uncertainty increase, the sector is less sensitive to the backdrop than others.

As we look toward the remainder of 2023, we believe that the sector will begin to show signs of leadership again as investors place more emphasis on stable company fundamentals and the significant alpha generating opportunity that broad innovation can provide. As a result, we think accelerating investment and innovation are not yet reflected in the price of many stocks.

The financials sector of the S&P 500 Index returned 5.3% for 2Q23 versus the 8.7% return of the S&P 500 Index. This positive return reflects the sector’s recovery from a difficult Q1 along with improving news on credit quality and balance sheet trends. All industry groups within the sector posted positive returns. Consumer finance and financial services did the best (reflecting “less bad” news on consumer trends).

Fallout from the first-quarter banking crisis was evident in continued deposit outflows at smaller institutions, though with a moderating trend following steps by the FDIC to fully guarantee deposits greater than the FDIC insurance limit of $250,000 at the failed institutions (Silicon Valley Bank, First Republic Bank, and Signature Bank). These actions calmed both depositors and investors, but without resolving the underlying issue of asset/liability mismatches on many balance sheets.

The sector’s focus continues to be directed toward liquidity and duration differences between a given bank’s assets (loans and securities) and liabilities (deposits and term funding). In addition to liquidity, we believe another key risk to banking health is the status of loan quality. Banks carry significant exposure to commercial real estate (CRE), which is experiencing significant secular (post-Covid) and cyclical challenges. As this economic cycle potentially turns, asset quality will need to be watched closely.

Future income statement pressure will come from continued labor cost pressures, but this is being offset by tech-driven efficiencies and generally better overall operation of businesses by management. Nevertheless, the market is less concerned with these dynamics and is solely focused on the expectation of a future economic slowdown and the course of Fed tightening.

Despite lagging the return of the S&P 500 Index during the second quarter, midstream energy gained ground again. Recessionary fears continued to weigh on the broader energy sector - as well as on crude prices despite OPEC’s best efforts to support the commodity - while natural gas finally saw some stability after two quarters of plummeting prices. While energy was one of the worst-performing sectors during the quarter and finished the period with a very slight negative return, midstream’s gain was solid. The sub-group has been the best-performing segment within the energy sector, both on a quarterly and year-to-date basis. For the full three-month period, the Alerian MLP Index gained 5.3%, but underperformed the S&P 500 Index by 340bps.

While some of 2022’s strong tailwinds have dissipated and macro uncertainties persist (weighing on energy broadly year-to-date), the midstream segment has bucked the broader trend. The group is well-positioned both near- and long-term, generating above-average cash flow yields while trading at a significant valuation discount to the broader market. We think this disconnect presents an opportunity given the significant transformation in the sector over the last few years. We believe the capital discipline shown by management teams will continue, the sector will remain free-cash-flow positive, and companies will continue to return capital to shareholders. Earnings results have been strong and share buybacks continue to provide valuation support.

Over the longer-term, midstream energy companies will play an important role in our energy future. The global energy transition will require multiple sources of energy to be successful and hydrocarbons—especially natural gas—will continue to have a role, driving future demand for the commodities and, more importantly to midstream infrastructure, the essential logistical systems that move them. Midstream energy infrastructure companies have difficult-to-replicate asset networks with high barriers to entry and adaptability to transport other energy sources that is underappreciated. Management teams are increasingly aware of the role they will play in our energy future, focusing not just on the environmental impact of their operations but also on how their asset bases can and will be part of a greener future.

Volatility in bond yields and falling power prices weighed on utilities during the quarter. It was another tough quarter for utilities as the market’s attention was captured by growth sectors at the expense of defensives and cyclicals. The group, as measured by the S&P 500 utilities sector (“utilities”), was the worst-performing sector of the market, underperforming the S&P 500 Index by over 1100bps. Apart from energy, it was the only sector to lose ground during the quarter. Utilities did relatively well in April as concerns about bank failure contagion still lingered, as well as sporadically throughout the quarter when recessionary fears spiked. But the sector lagged when the market turned its focus back to growth as concerns abated deeper into the quarter. Utilities finished 2Q23 down 2.5% versus the +8.7% return of the S&P 500 Index.

Despite a meaningful recovery in relative performance in 2022, the excess return gap to the broader market has largely closed this year. While fundamentals have remained strong, the group’s relative performance has struggled the last few years and, except for 2022, the utilities sector has been one of the weakest. However, even during the economic volatility of the past few years, companies within the sector have continued to execute operationally and deliver strong earnings while also de-risking their portfolios. Continued solid execution, along with the potential growth opportunities from renewable energy investments, should help drive the sector’s earnings going forward. In addition, continued recessionary concerns and a flattening yield curve remain tailwinds. Strong fundamentals and macro factors underscore the opportunity in the sector.