Although U.S. inflation remains higher than the Federal Reserve's 2% objective, the Personal Consumption Expenditures Price Index (PCE) has dropped to levels not seen before 2021: 3.8% each year, or 4.6% after adjusting for food and energy. With the unemployment rate remaining low at 3.7% and petrol costs falling to $3.50/gallon from $4.80 a year earlier, consumer demand is likely the driver of core inflation's stickiness.
June was the climax of the finest first half of the past quarter of a century for equity markets throughout the world. Top performers were U.S. stocks that are economically sensitive. Top performances among them were small-cap equities, which were less threatened by increasing interest rates, turmoil in the financial sector, and economic uncertainty. The consumer discretionary, industrials, and materials industries all saw increases of above 10%, but technology lagged behind.
Despite falling behind U.S. markets for a number of reasons, foreign equities returns were largely positive in June, helped along by a weakening dollar. Investors are pricing in a continuation of aggressive interest rate rises due to the persistently high inflation in Europe, particularly in the UK (almost 8% year-over-year). Due to the weaker-than-expected economic recovery in China, emerging markets have lagged behind the United States.
The yield on the 10-year U.S. Treasury note increased sharply towards the end of June, rising to little under 4% in early July from about 3.5% in March. Although the U.S. economy is holding its own, bond prices fell on the expectation that the Federal Reserve would resume interest rate rises in the coming months in an effort to further rein in inflation. As a result of increased issuance and positive spillovers from the stock market, high-yield bonds rose 1.6%.
Throughout much of 2023, real assets had significant challenges due to poor economic conditions and falling inflation. Real assets rise of 3% to 6% occurred in June, aided by signs of better-than-expected U.S. economic growth; but this rally was not quite enough to match the gains seen in the wider equities markets. Contributing to that total, commodities continue to be the worst performer so far this year, with a -7.8% performance; the energy subsector's 20% fall is the most significant drag.
Compared to high-quality bond markets, hedge funds have done better in the last year, and they had a little better June. Overall, long stock-biased hedging methods performed better than basic equity holdings (+1.3%), although they were still far behind. There was a clear uptick in convertible bond prices (+5.6%), and these hybrid instruments may provide an appealing risk-return tradeoff given their present good values.
Based on the impressive stock gains and very moderate bond performance, 2023 seems to follow the pattern of market behavior seen in the years after the 2008 financial crisis. Nonetheless, things are quite different economically now, with reduced unemployment and much higher interest rates and inflation. Ongoing geopolitical tensions and the fact that 2023 has seen three of the worst bank collapses ever are additional elements that may dampen market enthusiasm. Still, here we are, with markets reflecting rising consumer confidence.
Have we managed to avoid a recession and are now experiencing a new economic boom? I really doubt it. Given the Federal Reserve's expectations for more interest rate hikes and the emergence of indicators of economic decline, the likelihood of a recession is still high. U.S. manufacturing forecasts hit a post-Covid low of 46 on the important ISM PMI Index, banks have tightened their lending policies, consumer savings have dropped, and credit card and vehicle loan delinquencies have risen.
Although a majority of American households have secured long-term mortgage rates around 5%, which helps to mitigate the impact of rising interest rates, companies often use shorter-term loans that are slated to reset at much higher rates in the near future. Particularly in industries that are already short on funds, the result is uncertain. The ongoing economic tug-of-war is the subject of our Q3 2023 Commentary, which will be released later this month.
Private lending or distressed real estate debt may provide unique possibilities for investors ready to take strategic, maybe less liquid positions in the near future as a result of the shrinking credit available from banks and corporate debt markets. On a separate note, we're still dedicated to investing in infrastructure, which is a requirement for society in the long run and can only be met with a mix of public and private money.
It would be easy to assume everything is under control given the outcomes we have seen so far in 2023. Nevertheless, the fact that unpredictability is the sole constant is a lesson that investors have learned the hard way. In most cases, the smartest move is to reconsider modifications in the context of each portfolio's long-term goals. Similarly, some customers may find they can get away with less risk in order to earn the returns they need to achieve their objectives now that interest rates are higher. Even when credit is scarce, some people may still profit from illiquid assets because of the price they pay. Many new chances are emerging as the new market regime we are probably in develops, and we are assessing them according to the specifics of each client's situation.