A recession delayed
The U.S. economy has proven resilient to persistently high inflation, rising interest rates, ongoing geopolitical instability, and even domestic banking failures. A strong labor market, fueling solid consumer spending, has helped both economic growth and market optimism but in our view a slowdown and possible recession has most likely not been averted, just delayed.
Consider the consumer: consumption has been robust, surprising to the upside. At the same time, adjusted for inflation, spending has softened. Delinquencies are increasing on the margin and the surge in excess savings that accumulated during the pandemic has been whittled lower. Meanwhile, the strong job market that provided consumers’ confidence remains robust but has begun to show initial signs of softening. For example, the average work week has declined, suggesting slackening demand for labor, and job openings are down from their peak (although the Fed recently reported that openings remain at more than 10 million jobs). Finally, the Supreme Court ruled against the Biden administration’s plans to forgive student loan debt – whose monthly payments can be a significant portion of discretionary income.
More broadly, leading economic indicators continue to point to a more challenging environment over the coming quarters, and the yield curve remains severely inverted – which has often been a precursor to recession. Certainly, the combined rate hikes from central banks across the world are likely to be draining financial liquidity. And while the economic impact of this lags, we think it is a question of when, not if, the economy feels its full impact.
Ironically, a strong economy now increases the odds of recession down the road if it keeps inflation elevated due to several factors. Under that scenario, the Fed would raise rates higher, tightening financial conditions further, which in turn would raise the odds of a policy mistake and a recession. Calibrating rates accurately is an imprecise exercise given the lagged impact on the economy.
Bottom line: We expect economic growth to slow near the end of the year, with recently diminished but still significant odds of a recession in 2024.
Inflation has declined from the exceptionally high levels emerging from the pandemic, with consumer inflation, as measured by the Consumer Price Index (CPI), falling from more than 9% in 2022 to closer to 4% today. And while Core CPI (not including the more volatile food and energy components) has been stickier than most investors expected, there are increasing signs that it too is rolling over.
However, some stickier price indicators and the still-tight level of the labor market will continue to moderate the speed with which overall inflation can descend. Falling commodity – and producer – prices will help, as will the softness in rental markets and existing home sales, but we remain skeptical that inflation will decline to the Fed’s target level (2.0%) before falling economic growth forces it to abandon its fight.
Bottom line: Inflation has peaked but will remain high enough to force the Fed to stay hawkish.
Two more rate hikes
Although the Fed recently paused in hiking short-term interest rates, Chair Jerome Powell was recently clear that they expect to continue raising them. Currently, the bond market is pricing an additional 50 basis points (bps) of policy tightening, and we agree. In our view, it was logically inconsistent for the Fed to pause while simultaneously raising its inflation forecast and reaffirming its commitment to higher rates. But we believe that the muddying economic trends have created some doubts even among the Fed’s voting members, and skipping a month was an acceptable compromise between hawks (higher rates) and doves.
While we do think two more hikes is risky insofar as it increases the chances of a policy mistake (which could lead to a recession and a quick policy reversal to begin cutting rates), we expect the Fed to deliver the hikes, nevertheless. While the Fed has been the target of much political ire for hurting the finances of the average American, we believe their higher priority is confirming the Fed’s commitment to lower inflation, regardless of the political cost, as failure to quell inflation would do far more damage over the long run and severely dent the Fed’s credibility.
Bottom line: We expect the Fed will raise rates 25 bps in July, then another 25 bps in the fall.
Narrow equity breadth with challenges ahead
An irony of the recent surge in the S&P 500 Index may be that it is being buoyed by relief from so many underweight investors who expected that clear signs of an impending recession would have emerged by now. The odds of a soft-landing have increased given a resilient economy, but recession odds remain high heading into 2024.
While it is true that the more sanguine economic backdrop has led to better than expected overall corporate earnings and equity returns, these have been influenced by a very small number of mega-cap, technology-oriented stocks sparked by (justifiable) enthusiasm for artificial intelligence (AI) and all the infrastructure it requires.
These stocks pushed the S&P 500 to a year-to-date return near 15% by end June, but only 10 stocks (approximately 2% of the names in the S&P 500) are responsible for a vast majority of this performance. Put differently, if all stocks in the S&P 500 were equally weighted, the index would only be up by about 5% year-to-date, and this 10% differential is one of the widest on record.
Furthermore, profit margins look to us to have peaked. Broad-based corporate profitability, while better than expected, has been buoyed by the ability to raise prices in a stimulus-driven inflationary environment. But in an environment of slowing inflation and economic growth, it will be more difficult for corporate profits to continue to beat expectations.
All that said, we do think the market is right to see AI as the spark for a new, emerging trend fueling technology investment. And while there is justifiable debate about whether the market is being irrationally exuberant given high valuations, we note that when valuations of these mega-cap stocks are compared to the extremes of the Dot-com bubble, they look much more restrained than in those heady days. Put simply, these companies may be expensive, but they are making (lots) of money, unlike their Dot-com counterparts.
Additionally, we think it’s worth keeping an eye on small cap stocks. If history is any guide, the time to increase exposure to this sector is when the economy is in, or clearly headed into, a recession. Because timing the economic cycle is always difficult, we encourage investors to actively monitor both economic data and small cap valuations.
Bottom line: We remain neutral in our broad equity positioning but are more cautious heading into 2024 (given the lagged impact of tight monetary policy) and would look to take advantage of significant further strength to lighten exposure. We are more optimistic on the long-term outlook for the technology-related and small-cap sectors.
International stocks are less attractive
The European Union entered a (technical) recession the last two quarters, the German yield curve is deeply inverted, and the economic outlook for the United Kingdom looks quite challenged. Meanwhile, China’s recovery is wavering, and its leadership seems reluctant to open the floodgates to stimulate the economy given high debt levels. Also, consumers have been more cautious than expected coming out of COVID lockdowns. In our view, emerging markets equities globally are likely to remain challenged. Falling commodity prices, political instability, and the issues that the Chinese economy and geopolitics present, will most likely restrain performance from emerging market equities.
Japan’s equity markets have outperformed this year, in part on hopes of corporate governance reform elevating shareholder interests and nascent signs of inflation—a welcome event for a country that has battled deflation. Valuations remains attractive but, longer-term, Japan still faces challenging demographics and deflationary pressures.
Bottom line: Not much to be optimistic about here. Stay underweight.
Short-dates bonds are still attractive, and Treasuries may be soon
Money market yields continue to move higher with rising policy rates and are likely to reach 5% with another Fed hike. In our view, these funds remain an attractive area for savers or for the conservative allocation of an investor’s overall portfolio. For those willing to take a little more duration (a measure of sensitivity to interest rates) and/or credit risk, yields can be found between 4% and 8% depending on the sector, credit quality, and maturity.
Both short and intermediate bonds, with current yields of 5 - 5.5%, look especially compelling if the market is right that there are only a few more interest rate hikes remaining. Also, mortgage-backed securities which have recently seen selling pressure from troubled banks look appealing given their combination of very high credit quality and yields near 5%.
Investment-grade corporate bonds look attractive given lower credit risk, but we do not see the same value in the lowest spectrums of the corporate credit market, where high-yield (HY) bonds look rich. While absolute yields across the credit spectrum can be attractive to buy-and-hold investors, the likelihood of high shorter-term volatility makes a long-term view necessary. Additionally, we expect any further economic weakness will weigh more heavily on the lower-rated segments of the corporate bond market. Defaults are already rising, and signs are starting to emerge that it is becoming more difficult for highly leveraged high-yield companies to access financing.
Finally, we encourage investors to keep an eye on longer-dated U.S. Treasury bonds which, like small-cap stocks, historically perform well as the economy turns into a recession.
Bottom line: Short-term bonds are still attractive for yield and relative stability. HY credit looks tactically expensive but potentially suitable for long-term investors looking for yield. Longer-dated Treasuries could see lower yields as we get closer to year-end.
Proceed with care (and humility)
Turning points in the U.S. economy are notoriously difficult to time. And as the U.S. economy has become more global, the complex interaction of the various factors driving the domestic economy has only become more complicated. Today, geopolitical wild cards abound. Might we see a post-Putin Russia in the second half of 2023? How, and when, will the tensions between China and Taiwan be resolved? How convoluted and disruptive might the 2024 U.S. Presidential election become in the coming quarters?
Most investors are increasingly used to tolerating a steady stream of uncertainties. Most investors also thought a recession in early 2023 was highly likely. Turning points in the economic cycle are just that hard to time. We encourage investors to take some comfort in humility, stay focused on the longer-term trends and – absent clarity – wait patiently for clearer signs of the economy’s direction out of the muddy waters of transition.
Bottom line: Cautious into 2024 on equities and continue to favor higher quality issues within fixed income.