Q3 2023 Capital Markets Perspective

Where are the capital markets heading? Coming up, Thrivent’s chief investment strategist offers his outlook on rates, equities, credit markets and more.

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From Thrivent Asset Management, welcome to Advisor’s Market360™. A podcast for you, the driven financial advisor.

We are already past the halfway point of 2023. That makes this a good a time to reflect on what has already happened and look ahead to the rest of the year. As we often do, we asked Steve Lowe, Thrivent’s chief investment strategist, to share his insights, starting with a review on the first half of the year.

“Yeah, it's been a very resilient economy in many ways, despite higher Fed rates. And it's really not where consensus expectations expected the market or the economy to be. We've had a very, very strong equity market narrowly led by the mega caps, sparked in part by developments in artificial intelligence. And credit markets have also been solid: high yield bonds, investment-grade corporates have posted very good returns.”

The Federal Reserve, or Fed, has raised rates four times so far this year. Will there be more hikes to come? And how long before the Fed starts cutting? We wanted to get Lowe’s take on what he thinks the Fed will do going forward and how their actions might affect the markets.

“The market has pushed back what they expected to be Fed rate cuts this year into 2024. And that's really due to a strong economy and a very hawkish Fed, kind of higher for longer. But critically, inflation is decelerating pretty significantly and that's increased hopes of a soft landing.

“The one potential hitch is a stronger economy – if it reaccelerates, that may increase the odds that inflation stays more persistent. And if that happens, then you get the Fed raising rates again and then there's an increased chance of a mistake or recession.

“Going forward, I think, as always, the Fed is going to be critical, but also the economy, inflation, and earnings, along with breadth of the market.”

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Thankfully, the economy has held up better than most experts anticipated. Of course, many factors played into that turn of events, but we wanted to get Lowe’s thoughts on why the economy is doing well.

“Well, I think a key part of it is the jobs market has been very strong and it has been for several years now.

“And then consumption drives the U.S. economy. And that's been very strong, especially in services. And you're seeing the kind of areas that were hurt by the pandemic still rebound there, such as travel. The consumer is in very good shape overall. Debt levels are relatively low or are low. Savings are still solid.

“I think the key point is that inflation is subsiding.”

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Next, we wanted Lowe to give us his thoughts about the second half of 2023. Specifically, are we out of the woods, or should we all be vigilant about the economy? Recession or not, we asked for Lowe’s read on the road ahead.

“I think the best way to put it is I think the slowdown has been postponed, but not canceled. It's just got pushed back. GDP or the economy in the first half of the year grew at about 2%. It’s forecasted to soften some going forward. I think it's also important to remember that Fed rate hikes take time to impact the economy, anywhere from 12 months to up to a year and a half or two years.”

Based on that thinking, there seems to be a few possible outcomes—a recession, a slow down, or a soft landing. Lowe breaks it down:

“Well, as we’ve talked about, Fed cycles often end in a recession. And I think the odds are lower than they were a few months ago, but they’re still meaningful. But it’s more likely maybe the first half of next year or very late this year. And it’s not a given by any measure. The chances of a soft landing have increased significantly over the last several months.

“[There’s the chance of a] so-called immaculate disinflation where inflation subsides, and the Fed can cut. So, it could be different this time. Maybe the amount of money circulating still from the pandemic [will] allow people to get through this. But, I think it’s just that the slowdown will take longer to play out. If there is a recession, expect it to be mild. And if there isn’t, we’d still expect a slowdown.”

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While Lowe has a relatively positive view on the economy, the Fed does not necessarily agree. And while the Fed’s going to do what the Fed thinks is best, Lowe was willing to share his opinions on its actions and current posture.

“It’s still hawkish. They don’t want to repeat the mistakes of the 1980s and cut inflation only to have it come back. But there are very positive signs that inflation is falling. Goods prices are down. Used cars are a classic example of that. They ran up and they’re falling pretty quickly now. Rent is falling and supply chains have largely unraveled and pressures there have eased. And consumer price inflation, which people are most familiar with, has fallen from about 9% to 3%.

“The issue is that core services is more persistent and too high, and it’s higher than it was during the pandemic. And that’s a lot more sensitive to wage pressure.

“I think, looking forward, after the Fed hike in July, they’ll pause. There’s a decent chance they hike in September, but then they [would] hold rates high into next year while they assess the impact, at least that’s [the] expectation that they will do that.”

After many quarters where the Fed has risen rates, we wondered when they would start to move in the other direction. Lowe weighs in…

“I think there's a substantial risk that they will have to cut earlier than expected as the economy slows and inflation falls further from the impact of higher rates over time. The risk of that view is that inflation does stay high longer and then they do have to raise rates again. And that’s not good for the economy.”

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As we move into the second half of the year, another thing we wanted to hear was Lowe’s thoughts on the impact of tighter financial conditions – and not just those being delivered by the Fed.

“Yeah, it’s not just the Fed. There are a number of other elements that impact it. And the Fed obviously is in the most aggressive cycle in 40 years. So, it’s a shock when rates shoot up from basically zero to relatively high levels. But banks have been tightening credit standards and they’re charging more for lending spreads. That has an impact. Mortgage rates are higher, and it takes time, though, for that to have an impact. Consumers and companies are locked into low-cost debt, but eventually they have to refinance and that’s when it has an impact.

“So, we’re already seeing signs of higher stress. I think the banking failures were partially related to that, [like with] Silicon Valley Bank. Commercial real estate is challenged by higher rates. They have other issues like office vacancies with hybrid work. And I think another area to watch is the private debt market. There’s a lot of leverage there. It’s maybe a bit of a bubble. And the rates will hit as refinancing gets harder. So, I don’t think we’ve seen the last of the impact of higher rates.”

We wanted to dig a little deeper on the subject of Fed rates and its impact to Treasuries. Here are Lowe’s thoughts on where rates are headed for the remainder of the year.

“Yeah, I think the Fed stays high, but I think Treasury rates are going to fall, particularly longer-term rates up to the two-year. We are positioned [towards] long duration, which means we’re taking interest rate risk now because we expect rates to decline as the economy slows and inflation tails off. And that’s what typically happens when the Fed stops hiking. If you look at Treasury curves, they have been deeply inverted and they should steepen going forward. That’s what happens in front of a recession or slowdown as short rates come down and [with] expectations of Fed cuts.”

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Of course, discussion around the Fed seems inescapable as its actions seem to affect every corner of the markets. Nonetheless, we shifted to Lowe’s thoughts on the equity market.

“Yeah, equities have done very well as the Fed pause approaches, and that's typical as markets look toward a Fed pivot and a greater chance of a soft landing.

“But what really stands out is the narrow breadth of the market. A handful of mega caps have driven the market. The seven largest equities in the [S&P 500^® index] – and they're mostly tech – have driven half of the first-half performance. And they're sometimes called the Magnificent Seven – household names you know: Meta, Apple, Amazon, Microsoft, Google, Nvidia and Tesla. And the other thing is that there's safety in mega caps. So, if you expect growth to slow, these are solid companies, they have strong cash flow, solid balance sheets.

“One of the issues though with narrow breadth is valuations, and they're rich compared to history. And if you look at what's driven the market, it's been an increase in valuation this year because earnings have not grown this year. But it's not like the tech bubble. These companies actually have profits and ultimately earnings will drive the market.”

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Based on Lowe’s insights into the economy and the markets, we wanted to get his thoughts on how Thrivent Asset Management is positioning portfolios for the rest of 2023 and the early part of 2024.

“Yeah, we've been moderately overweight equities all year. Our long-term default is to be more significantly overweight because equities outperform over the long run. We intend to remain overweight, at least for the near term as the Fed cuts approach. But I expect we’ll turn more cautious as we get closer to 2024 and [as we anticipate] a slower economy and earnings. Then, when there is a correction, we'll be looking for opportunities.”

Within equities, we wanted to get Lowe’s thoughts on how he’s positioned, such as style basis and market cap. No doubt growth has crushed value this year with the mega-cap market leaders placed on the growth end of the spectrum. Lowe added:

“You see signs of growth in cyclicals improving. But we expect quality companies to continue [outperforming] as earnings slow because they do have strong earnings and are supported by strong cash flows.

“[Small-cap stocks] has trailed year-to-date. [That segment has] done a little bit better more recently. The values look attractive, but I think it's a little early because the time you really want to buy small caps is into a cyclical turn or ahead of a cyclical turn and we don't think we're there yet. So, that's maybe later this year or 2024.

“International equities look very cheap, but they're going to be more cyclical and hit by a global slowdown. And there's secular headwinds in a number of [those] markets.”

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A final area where we wanted to get Lowe’s outlook was credit markets. Specifically, where he feels the risk/reward is most favorable.

“Yeah, I think we, going forward, favor higher quality and duration versus lower tier credit risk, like high yield would be in a lower tier credit. So, that would leave us with investment-grade corporates – they’re much more stable and higher quality.

“High yield [bonds are] certainly not priced for a downturn. It looks very rich. Defaults could rise meaningfully in a downturn. We've already seen leveraged loans default rates tick up pretty significantly. So, we're trying to be patient. We would add at more attractive levels in credit, particularly high yield.

“If you’re a yield-based investor, yields look very attractive. If you can deal with the market-to-market volatility, I think it's a good time to look for yield in the market.”

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We hope you found this capital markets outlook to be informative and helpful. A special thanks to Steve Lowe for his insights. You can find more episodes of Advisor’s Market360™ wherever you listen to podcasts. Email us at podcast@thriventfunds.com with your feedback, questions and topic suggestions for future episodes. And as always, you can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.

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All information and representations herein are as of August 1, 2023, unless otherwise noted.

This podcast refers to specific securities which Thrivent Mutual Funds may own. A complete listing of the holdings for each of the Thrivent Mutual Funds is available on thriventfunds.com.

Past performance is not necessarily indicative of future results.

Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.