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Economic and Financial Market Outlook Q3 2023

Friday, July 14, 2023

Prepare for a Soft Landing

The global economy continues to slow, but the US and euro area should avoid recession, albeit narrowly.  We expect a positive global GDP growth surprise of 3.0% to 3.5% for 2023, based in part on the anticipated boost from coming stimulus in China.  In the second quarter the views of the most probable US scenario shifted from recession to “soft landing,” which reflected the capacity of the economy to withstand inflation and higher interest rates. We now estimate the likelihood of a recession to be below 20%. The improved environment raises prospects for the US stock market and reduces the probability of a renewed bear market. We are cautiously optimistic regarding a further advance of the S&P 500 Index, but we note that this Index over the last six months has featured extreme divergence in the performance of different industry sectors and market capitalizations. This is unhealthy, and a near-term correction is possible. The arrival of more favorable macro conditions should broaden participation and makes a future market advance more sustainable.

US Economy Refuses to Quit

So far this year, the US economy has exhibited surprising strength. In the first half of 2023 there was plenty of bad news: the Federal Reserve hiked rate above expectations, inflation declined at a disappointingly slow pace, major banks failed, the government tottered on the brink of default, international economies were weaker than anticipated, manufacturing indicators contracted, and recession predictions were ubiquitous. Yet the economy continued to grow. US GDP rose 2.0% in the first quarter, and we expect a similar result for the second quarter. The major support for the economy has been the labor market: the unemployment rate has settled near a 70-year low and job creation has been vibrant.  Home prices and sales have remained firm despite a sharp increase in mortgage rates, and consumer sentiment and spending data have been encouraging.  As the quarter drew to a close, there was a notable jump in optimism that the soft-landing scenario was the most probable.

What does a soft-landing look like?

Over the next two quarters, we expect GDP growth to approach 0.0% but remain positive, as the lagging impact of previous Fed rate hikes takes its toll. Annual CPI inflation will continue to decline gradually from its current 4.0% but remain above the Fed’s 2.0% target.  We estimate two more quarter point rate increases, the first in July and the second in September.  By the end of the third quarter, the Fed will be satisfied with the reduction of inflation from its peak of 8.3% in 2022 to below 3.0% and decide to pause rather than raise rates further but we do not expect any decisions to lower rates until well into 2024.   Despite higher rates, the labor market will stay strong with the unemployment rate below 4.0%. As was true in the first half, this positive scenario will be driven by the resilience of consumers and businesses spending and investing despite the headwinds of inflation and worries of an impending recession. The housing and auto markets should remain healthy. Recent, successful stress tests administered to banks have been encouraging and we think another banking crisis is unlikely. While all of this should be welcomed as good news, conditions are intended to remain tight to slow the economy and GDP will be on the cusp of contraction. There remains a lot of progress to be made before we are on a path of healthy, sustainable growth.

US Stock Market Resilient

The unexpected strength of the US economy drove equity markets to advance in the first half of the year. In the face of a slowing economy and a forecasted recession, high inflation and rising interest rates, and fear of government default, the market rally was certainly a surprise to investors. While the S&P 500 index had the strongest performance, most broad market indexes provided positive if unspectacular single digit returns:

12/31/2022 - 6/30/2023 Total Return
S&P 500 Equal Weighted Index 7.0%
S&P Mid Cap 400 8.8%
S&P Small Cap 600 6.0%
Russell 2000 8.1%
Dow Jones Industrial Average 3.8%
Source: FactSet

7 of the 10 Industry sectors of the S&P 500 Index returned less than 10%, and 5 were negative or flat: consumer staples (0.0%), financials (-1.5%), health care (-2.3%), utilities (-7.2%), and energy (-7.3%).

In sharp contrast is the truly remarkable performance of technology stocks and especially the largest stocks by market capitalization (see our 6/2/23 blog, “2023 US Stock Markets: The Year of the Giant.”). For the six-month period, the technology heavy NASDAQ Composite and the information technology sector of the S&P 500 Index rocketed 31.7% and 42.1% respectively, and the six largest companies measured by market capitalization rose an average of 85.3%: Alphabet 36.3%, Amazon 55.2%, Apple 49.7%, Meta 138.5%, Microsoft 42.7%, and Nvidia 189.5%. These giant companies have a combined market cap above $9.4 trillion, or about 26% of the total S&P 500 Index. This is the reason the S&P 500 Index (+15.9%) was such an outlier in the first half. As we pointed out in the blog, the S&P 500 Index was not representative of overall stock markets and well-diversified portfolios saw more modest single digit returns in line with most other indexes.

For the rest of the year, we expect the path of inflation and the response of the Fed to be the major focus of stock investors. Based on our forecast for a continued decline in inflation, we expect the market rally to extend through the end of the year. Although additional rate hikes are coming, investors expect this and the modest increases should not pose a significantly larger obstacle than the previous 500 bps.  We project corporate earnings will turn positive again in the third quarter and accelerate in the fourth quarter, justifying current higher price multiples. Our positive forecast includes a broadening of market participation away from a reliance on the largest stocks mentioned above.

International Green Shoots

In China, the financial market situation has turned ambiguous after a brief surge earlier this year. A short-lived rally in stocks faded as the economic headwinds arose. In response, the government has resorted to stimulus measures to invigorate the economy, and we anticipate more in the pipeline. Contrary to the rest of the world, China has faced deflationary pressures, underscored by June’s negative core CPI. While deflation has presented a challenge for the world’s most populous country, it has benefited the rest of the world where inflation is still an obstacle.

Turning to the European Union, the economic landscape more closely resembles the US, albeit on slightly weaker footing. Harmonized CPI inflation has cooled from 8.5% in February to 5.5% in June as growth stalled. Though consumption and manufacturing have been contracting, we may be seeing early indications that the worst is behind us. If this is indeed the case, the EU will emerge from this slowdown without a substantial rise in unemployment, which could lead to a rapid recovery. A noteworthy risk remains the ongoing conflict in Ukraine, with the potential to cause supply shocks and exacerbate geopolitical tension.

Recoveries in other international economies have added to our cautious optimism. India’s growth has accelerated even while inflation has retreated. Similarly, we are seeing robust momentum in Mexico and much of Latin and South America, despite some political turbulence. Japan, too, presents an encouraging picture with a 17-month high in consumer confidence and a low unemployment rate of 2.6%.

Fixed Income and Higher Rates

The recent bond selloff has brought rates back near the highs set late last year. The 10-year Treasury yield approached 4.0% at the end of the quarter and briefly exceeded that in the early days of July. As investors’ appetite for risk assets like stocks grew, coupled with their acceptance of higher fed fund rates through 2024, perceived safe assets like treasuries were out of favor. As a result, new fixed income investments are providing the most attractive real yields in over a decade. The yield curve remains inverted which means both that there is still an expectation for recession in the near future and the best yields are in short maturity bonds. In this environment, it is worthwhile for balanced portfolios to consider whether bond investments can now be a greater part of their strategy but we continue to recommend that investments focus on high-quality and short duration selections.