Q3 2023 Market & Economic Outlook
Despite the Federal Reserve rapidly raising interest rates to slow the economy, much of the economic data remains fairly strong. While rate hikes are important, the central bank’s actions to take money out of the economy is growing in importance.
Q3 2023 Market & Economic Outlook
Current Economic Views
Many economists and market participants originally predicted a recession would have arrived by now. The thought was the Federal Reserve’s aggressive interest rate increases would slow the economy down more than it has.
The consumer and the labor market have been surprisingly resilient through the interest rate increases. In short: There are not enough workers in the U.S., which is making the Fed’s mission to cool the labor market difficult. The lack of workers is creating sizable wage gains too.
The number of job openings in the U.S. has hovered around 10 million for months with little signs of decreasing. This is a big reason inflation has been so sticky.
Consumers are getting a boost in real incomes as inflation subsides, a banking crisis has so far failed to materialize despite tightening capital and lending requirements, and the agreement on the debt ceiling leaves overall fiscal stimulus intact.
The Fed is shrinking the U.S. money supply by roughly $90 billion a month. It will take months for that figure to reach levels the central bank wants.
The U.S. economy is like a barge. It takes time to change direction unless a dramatic event occurs. Tightening is occurring, but it is taking longer than originally envisioned.
A severe economic downturn is becoming less likely, which is certainly a positive. The flip side though is we may have sluggish economic growth for the foreseeable future. In a slow growth environment, it is especially important to watch expenses while also making sound investment decisions.
If the economy falls into a shallow recession in the fourth quarter of 2023, it won’t be much of a surprise. Conversely, with so much anticipation, it is equally plausible that consumers and businesses will adjust spending and output preemptively thereby avoiding an actual economic contraction. The Fed not overshooting their target is important.
The central bank is keenly focused on the labor market, particularly the overhang of excess demand for labor which it sees as a major source of wage inflation. While there are signs that inflation in general is cooling, the service side of the economy is still struggling with labor costs. The Fed is concerned that backing off rate hikes now and leaving the labor market in its current imbalance will not fully subdue inflation.
Several significant components of inflation are poised to improve in te second half of this year, thus lowering the odds of a deeper or protracted recession.
Core goods inflation will continue to decline, led by used car prices and improving supply chains. The shelter component of CPI, which lags, will likely fall despite an increase in home prices because the cost of renting is trending lower.
Current Investment Views: Equities
The equity markets performed strongly in the second quarter, driven by a resilient U.S. economy. Real economic activity surprised as job growth and household spending held firm.
Various factors including lower inflation readings, the agreement on the U.S. debt ceiling and better than expected first quarter earnings all helped fuel upward momentum in equities. At this juncture, the outlook for the economy has become less pessimistic with the timing of a slowdown getting pushed further out into the future. Confidence has improved that the nation will experience a more moderate, short-lived reduction in activity and miss the highly expected consensus view of a recession.
Positive returns were seen throughout the market in the second quarter. The S&P 500 gained 8.7%, the Nasdaq increased 13.1%, and the Russell 2000 improved 5.2%. Advancements were dominated by mega-cap stocks with the prospect that artificial intelligence will have a significant impact on productivity through advanced data analytics, decision-making and innovation.
Seven stocks led market returns with Apple, Microsoft, Amazon, NVIDIA, Alphabet, Tesla, and Meta rising by a combined 28% average rate of return for the quarter. Year to date, the average return of the seven stocks is an outsized 90% with Nvidia leading performance by increasing 190%. These seven companies make up 26% of the market-cap weighted S&P 500, and Apple’s market capitalization now exceeds that of the entire small-cap Russell 2000.
Although estimates reached a trough in the second quarter, earnings revision trends are still skewed to the downside.
Warning signs of slower growth continued to emerge with the inversion of the yield curve, tightening lending standards and weakening manufacturing activity. However, these forward looking measures did not derail the markets.
Forecasts by practitioners of a stalling economy earlier this year have yet to be fully realized with the hard data stable and running counter to their predictions.
While central banks in the U.S., U.K., Eurozone and other nations continue to tighten monetary policy, progress is underway to bring inflation back down to target levels. With continued improvement on the inflation front, a pivot in monetary policy toward lower interest rates is expected to begin and accelerate globally in 2024.
Companies expect the outperformance of services over manufacturing to continue in the second half of this year.
As interest rates peak and tighter credit conditions ease, global growth will likely improve next year with a better balance between supply and demand. This should help broaden performance in the equity markets to include more countries, sectors, and securities instead of only a select group of tech-oriented growth companies, which has been the case this year.
Current Investment Views: Fixed Income
It was a mixed second quarter for the bond market. On the credit front, U.S. investment grade bonds posted slightly positive total returns of 0.1% and outperformed intermediate-term Treasuries which fell 1.15%. High-yield bonds had positive returns of 1.6%.
Treasury yields climbed during the second quarter as the debt ceiling debate affected the market. Economic data continued to show upward persistence and changed the consensus view that the economy was destined for a recession. The outlook shifted to a soft-landing scenario. This caused investors to expect the Federal Reserve to continue with rate hikes over the near term and hold them at higher levels rather than cutting later in the year.
As the quarter unfolded, the yield on the 10-year U.S. Treasury rose 33 basis points to 3.81%, while the 2-year U.S. Treasury note increased 81 basis points to 4.87%. The spread between the 10-year and 2-year Treasury yields further inverted, dropping to -106 basis points. This extreme level has not been seen since 1981 when inflation was running above 10%. An inversion typically warns that growth prospects for the economy are vulnerable over the near term.
There have been false signals in the past where the yield curve has inverted without a recession taking place. The average lag time between inversion and recession normally falls between 12 to 24 months. The current inversion began 12 months ago so there is still a high level of uncertainty regarding the recession threat level to the economy. What is known with a high degree of certainty is, given the Fed’s aggressive rate hiking cycle over the past year, the extent of tightening monetary conditions has yet to be fully absorbed into the economy.
After 10 consecutive rate hikes totaling 500 basis points, the Fed decided it was time to pause in June and hold the Fed Funds rate in the 5-5.25% range. Policymakers agreed that it was time to evaluate whether tighter monetary conditions were having their intended effects of slowing growth and inflationary pressures.
The Fed’s Summary of Economic projections indicated that two more 25 basis points rate hikes were anticipated to take place before the end of this year. The pause in policy delivered was viewed as temporary since the central bank remains uncomfortable with inflation still above its 2% target. Yet, the extent of further monetary policy tightening is expected to be limited and viewed as conducting some critical end-of-cycle fine-tuning.
As we get closer to the end of the Fed’s hiking cycle, improvement in the returns of U.S. Treasuries is likely to unfold. With the current inverted yield curve and high cash yields, the short end of the fixed income market has garnered high interest by investors.
However, should the growth outlook deteriorate, the performance of longer-dated bonds will improve as yields decline and will act as a good ballast to portfolios if equity returns come under pressure due to weakness in earnings.
Asset Spotlight: Housing
Housing affordability is at its worst levels in decades in the U.S. This could present an issue since the housing market is often part of the answer to lifting the country out of a recession. While the economic news is still mostly positive, a slowdown to some degree is expected within the next year.
In the wake of past recessions, the housing market often serves as a "reignition switch" for the economy, helping to jump start the new market cycle.
Several key forces come together to make this a relatively reliable mechanism:
- Home prices tend to fall during recessions – not as drastically as stock prices, but single-family home prices typically soften up when economic growth turns negative.
- At the same time, the Federal Reserve's monetary policy response to a recession almost always includes a reduction in interest rates.
- The confluence of these two factors translates to a rapid improvement in the affordability of buying a home.
Buying a home is a significant purchase, but it also marks the beginning of a domino effect of economic activity at the individual level. The chain reaction of spending includes some combination of new debt financing, new insurance policies, logistic expenditures, landscapers, decorators, renovation contractors, furniture, self-storage needs and more.
That translates to a significant macro-economic impact when housing market activity picks up in the aggregate.
No other purchase consumers make has such a compounding ripple effect on the economy. All the activity can often be traced back to the recession that marked the end of the previous market cycle, softening the housing market and pushing the Fed to reduce their policy rate.
Today, the housing market is incredibly tight, thanks to the fact that buying a new home for many would mean doubling their mortgage rate. With housing affordability at a historically low level, and broader inflation still relatively high, the irony is that a recession might fix part of the issue.
Without a recession, and without the housing market catalyst that would likely come along with it, the economy may just continue to muddle along – not quite tripping and falling, but also not striding forward with much pace or confidence.
Whether a recession is coming, when it may come, and how severe it is likely to be are all questions with fewer and fewer concise answers because economists and market participants continually revise their expectations for the next twelve months.
There will be pain if a recession occurs, but the silver lining is it could ease the housing affordability crisis we are currently in.