Branstad: Hi, everyone. Welcome to Thrivent Asset Management's Equities Overview for the third quarter. My name is Jeff Branstad, I’m a portfolio manager here at Thrivent and this is Steve Lowe, our chief investment strategist.

So, Steve, we're about halfway through 2023 and equities have fared much better than expectations were at the beginning of the year. What's been driving that?

Lowe: You’re right. A lot of forecasts and strategists expected markets to be flat-to-down, but the economy and better earnings have helped markets significantly. If you look at the low in equities this cycle, that was October of 2022, that was down about 25%. So, that's somewhere around what you would get in a light recession. But they've nearly reversed all of that heading into the second half of this year. The reasons are that the consumer's in good shape and the job market remains strong. But, a key is that inflation has been easing.

We're getting close to the end of the Fed cycle, when hopes of a soft landing and lower rates increase. We got through the debt ceiling as we expected. And going into this year, a lot of investors were positioned short or light on it, and since the market has been up, they've been chasing it, which leads to buying of the market and it helps drive it up.

And, importantly, artificial intelligence and the hopes for that and its impact have really helped drive tech this year.

We’ve been overweight equities moderately, not as much as our typical long-term strategy, which is to be more overweight given that equities outperform over time, and we've resisted cutting equities too early.

Branstad: That’s good. So, equity performance has been good, but it's been really driven by a handful of names. Why do you think that market breadth has been so narrow?

Lowe: It's been one of the narrowest markets on record. So, if you look at the Nasdaq 100 index, which is [comprised of] large-cap tech names, they had a record first half – up about 40%. So, that outperforms about 80% of the full years historically that the Nasdaq 100 has posted.

And it's driven by a handful of mega-cap names, the so-called Magnificent Seven. Those seven stocks drove the S&P 500® index. The average return in the first half of the year was 90% for [those stocks] versus single digit returns for the rest. They're household names: Apple, Amazon, Meta, Microsoft, Alphabet, Tesla – and Nvidia, in particular, was up more than 200% in the first half of the year.

So, what that's done is, market cap indices like the S&P 500 have done well in the large-cap space. The S&P 500 was up about 16% versus an equal-weighted index in which every stock is worth the same, which was up only about 6%.

Why are people focusing on the mega caps? Partly in a slowing economy, you seek safety in secular growth, which these names have, as they do have strong earnings and cash flow. But also, artificial intelligence and the long-term promise of that and future earnings have really supercharged returns for certain names.

Branstad: With the very narrow market space, is there any real concerns about having that be such a big driver?

Lowe: Yeah, absolutely. The market needs to broaden. If you look at history, periods of concentration revert eventually. They always do. And markets broaden and equal weighted indexes outperform. You saw some hints of a broadening early in the third quarter: small caps are faring better, and cyclicals.

One of the big issues is that the valuations are really extended. The indices are rich to long-term averages and median if you look at the Nasdaq, if you look at the S&P 500.

But I think it's important to note that this is not the tech bubble. There's no Pets.com, I don’t know if you remember that.

Branstad: Yeah, they're not part of the Magnificent Seven.

Lowe: That was the poster child of the tech bubble. [Instead,] these are real companies that are very profitable, and they kick off a lot of cash. They're rich, but they're nowhere near where companies were in the tech bubble.

Branstad: So, how do you see the rest of 2023 and moving into 2024? How do you see the rest of this year playing out?

Lowe: We're more positive than we were earlier in the year, particularly over the near term, –again, given the better-than-expected earnings and economic strength. But we’re cautious heading into 2024 and the issues there are valuations, and again, the narrow breadth.

While the economy has held up well, there are signs of strains: in consumers, manufacturing is weak, and trade in particular is weak. And you have all these leading indicators at recessionary levels. Fed hiking cycles have challenged markets traditionally. I don't think it's really different this time. I just think it'll take longer to play out, partly because of the stimulus that was received and there's still a lot of excess money circulating in the economy.

I think it's important to remember, though, that rates act with a lag. It takes time. Any significant slowdown isn't showing up quite yet. But, if it did, it would be more into next year.

So, we expect market volatility going ahead and we tend to look for opportunities – if we do get significant corrections – to add risk later this year or into next year. And what we focus on are typical signs: that earnings are starting to turn, that they're improving, that revisions are turning up, that the economy is bottoming ­– typically, if you look at ISM, a manufacturing survey, that typically bottoms in the middle of a downturn or a recession – and that the Fed is getting closer to actually cutting. Markets typically rally with a cut. A pause is already priced in, but certainly not cuts at this point. The market expects [cuts], but they’re not priced in.

Longer term, we’re really positive on the economy. There's a number of secular trends. Artificial intelligence, I think, will be a game changer. It will have a significant impact on increased productivity. There's a really strong technology capital spending cycle right now. Part of that is tech driven; part of that is reshoring ­– people are bringing back manufacturing here. Manufacturing is strong and the consumer is not overleveraged.

Branstad: You touched on earnings a couple of times. Can you give us your outlook on the earnings picture?

Lowe: – which is important because earnings ultimately drive markets. So, consensus calls for a bottom sometime in the second quarter before recovery. The full year consensus estimates are about flat, and then going up 12% next year. That looks high right now. First quarter earnings beat expectations, but they're significantly lowered. But I do think that, going forward, the estimates need to come down.

One of the big issues is that inflation is falling. So, when inflation is falling, it's really easy for a company to raise prices and get higher revenue growth, then it's easy to add expenses. But then as inflation comes down, those costs are a lot stickier; they fall a lot slower and you get margin compression and negative operating leverage.

You've already seen estimates for this year fall from the high point, which was about a year ago. Consensus is flat, as I mentioned, for all of 2023. But that looks too high because in a recession – which we’re not saying will necessarily happen – actual earnings fall about 12% to 15%, somewhere in that order. And we don't expect that, but we expect more weakening that just flat.

Branstad: Yeah. So, you'll be certainly keeping a close eye on the earnings as they come in. How about different areas of equity markets? What's your view on smaller-cap stocks?

Lowe: They have been cheap and they continue to look cheap versus large caps and history. But, as we've talked about, in the past, valuation is a really poor predictor in the short term of returns. Small caps tripled in the first half. They started to do a lot better in the second half of the year. The risk is that they tend to be more cyclically driven and they struggle in a slowing economy. They tend to perform best as the economy bottoms, or when people are anticipating a bottom and a cyclical upturn.

So, it's not really the optimal time, I think, to increase exposure at this point. When you want to add again is when fear is high, sentiment is poor, and in particular, the one signal that is not on is that credit spreads have not widened, as there's a correlation with small caps and credit spreads. So, we're watching for opportunities to add to our positions there.

Branstad: How about on style basis, growth versus value?

Lowe: Growth is outperforming right now. And that's all mega-cap driven and tech driven as people seek the safety of mega caps with growth, and AI just accelerated and supercharged that. I do think that growth will get a tailwind if the economy does slow. As far as being stronger and more secular growth in a slow economy, people pay up for growth. Value is much better in a upturn, in anticipation of a cyclical turn.

We think the areas of focus are quality, strong cash flow, strong balance sheets – in other words, companies that can sustain earnings in a slower economy.

Branstad: That covers the domestic space. Let's jump overseas – what are your views on international right now?

Lowe: Global equities excluding the U.S. have trailed so far. The EM – emerging markets – are lagging. A lot of that is in part due to China. Europe is lagging a little bit.

So, looking at the developed markets: going forward, on a positive side, there's valuation again. Europe and Japan look cheap, but valuation, again, is a poor indicator of short-term returns. International returns should be helped by a weaker dollar, which is happening. If the economy does hold up, they are more cyclical and should do very well.

But there are headwinds: core inflation is very high in Europe, the ECB is very aggressively raising rates, and inflation is particularly sticky there. They've already had a technical recession in the European Union – two quarters of negative growth. And manufacturing is very weak. I think the lag impact of higher rates has been fully felt.

If there is a slowdown in the global economy, which there is now, Europe tends to be more cyclical, and they're more tied to China.

Also, there are key structural differences between the European market and the U.S. The U.S. is much more tech-heavy [which is] transformative and much more profitable. Margins are higher here than they are in Europe.

One area that's been very interesting is Japan. It has outperformed this year, and it's on hopes of reform in corporate governance and hope of a more shareholder-friendly posture because traditionally, they have not been ­– but also, increased innovation. The negative is that Japan is more tied to trade. But overall, we've been more and more positive on that.

Looking at developed markets globally, we've been moderately underweight. In emerging markets, we've been slightly underweight. Valuations there, again, are attractive. China is kind of sputtering. They’ve had very disappointing growth; the consumer is holding back; the real estate market is still a mess; manufacturing is slow. They’ve been very reluctant to stimulate too much. We do expect more going forward, so we're watching that closely right now.

And overall, with emerging markets, if there is a downturn, it's going to be more cyclical and tied to trade. And you see that, already, exports have been very weak in South Korea and Taiwan. We'll watch for signs of bottoming, possibly to get more aggressive there.

So, overall, we’re modestly underweight international.

Branstad: But slightly more favorable to emerging markets versus developed?

Lowe: Exactly.

Branstad: Okay, excellent.

Well, thank you so much, Steve. That was an excellent overview of our positioning on equities.

And thank you all for joining us today. Please remember to visit us at thriventfunds.com for more insights and we'll see you next time. Thank you.