Many travelers will hit the beaches this summer, while market watchers keep an eye on the horizon for the next big wave that may impact investment returns. This year, Artificial Intelligence (sometimes referred to as “AI”) technology has become a significant driver of total market returns with new developments in products and services coming online every day.

In some ways, 2023 is shaping up to be the year of Accelerated Investing: Technology and AI-related stocks have outpaced more mature or defensive companies, fueling a 17% gain in the S&P500 in the year’s first half. This quarter’s letter will review new technologies such as AI in the broader context of an economy inching towards a likely recession and possible outcomes during the second half and beyond.

ChatGPT takes the market by storm

Chat GPT is an artificial intelligence “chatbot” that creates content such as essays, articles, computer programs, and even artistic output including images, music, and poetry. A new version of ChatGPT launched late last year and has attracted massive attention from a wide range of users. The adoption of this technology has been astounding, outpacing other widely used apps such as Instagram, WhatsApp, and Spotify.

AI programs such as ChatGPT use a lot of semiconductors to move information back and forth at high speeds. Investors anticipate a wave of new AI demand driving growth for semiconductor and related companies, which has been reflected in rising share prices this year. Excitement for new AI technology has more than offset other market challenges this year including a regional bank crisis, concerns over commercial real estate, and worries over the Federal debt ceiling.

The economic slowdown continues

Despite the enthusiasm for AI, rising stress in the financial sector is a reminder that the economy may be edging toward a recession. So far, we’ve seen higher rates play a role in the regional bank crisis that erupted this spring, while also mounting pressure in the commercial real estate industry. No doubt higher rates were also on the minds of policymakers as they hashed out the details of the debt ceiling and contemplated the rising costs of our country’s debt obligations.

In addition to these pressures on the financial system, we are also watching inflation and the job market, which are commonly viewed as bellwethers for the economy’s general health. The Fed’s rate hikes are gradually pulling down inflation, while also taking pressure off a tight job market (as seen in rising jobless claims and lower demand for workers).

The Fed faces the challenging task of slowing the economy while avoiding excess tightening that could push the economy into a recession. We anticipate Jay Powell may raise interest rates one or two more times this year to prevent runaway inflation and continue slowing an overheated job market.

Many signs from the economy and financial markets are pointing to a slowdown, but investors are struggling to project when it will start and how long a slowdown could last. Our sense is additional Fed rate hikes could trigger a recession within the next year. While the prospects of a recession raise some concerns, we would frame the situation as a normal part of long-term economic expansion in which we typically see longer cycles of growth followed by shorter periods of slowdowns.

Positioning for a recovery

With growth stocks driving markets up and a recession looming, we see two significant decisions ahead. The first is whether to remain fully invested ahead of an economic slowdown. Despite the possibility of a slowdown in corporate earnings and economic data in the near term, with history as a guide, we expect a significant recovery on the other side. From a strategic perspective, we prefer to remain invested throughout the cycle, rather than try to time a market move before and after a recession.

A second issue for investors relates to AI and high-growth stocks. Investors are debating whether to chase these high-growth companies and risk being left out. Alternatively, we could be at a near-term peak for AI and tech stocks, potentially followed by a rotation back to safe and slow-growth sectors.

Our investment selection process favors diversification across a spectrum of growth and defensive sectors. We strive to own high-quality companies whose management has demonstrated an ability to meet or exceed investor expectations, while also seeking attractive valuations. We continue to follow this process, especially because other changes in the broader economy could impact the attractiveness of growth or defensive stocks as we get into the second half of the year. Additionally, the string of Fed rate hikes has opened an attractive opportunity to lock in high-quality bond holdings with favorable interest rates that mature at the end of the decade and beyond.

As we wrap up, we continue to watch macro trends such as AI and evaluate the impact of a potential slowdown in the economy. We remain committed to owning high-quality assets through the cycle as we look to the next recovery. Looking ahead, we are guided by our core investment principles, which include a flexible, yet consistent approach to uncovering opportunities and remaining ever-mindful of your goals and objectives.

Michael Bailey, CFA
Director of Research

Jane DeLashmutt O’Mara, CFP®
Senior Portfolio Manager