July 21, 2023
The US economy showed remarkable resilience in the first half of 2023 despite facing significant challenges, including the regional banking crisis and debt ceiling standoff. With falling inflation and a Federal Reserve (Fed) that seems to be nearing the end of its interest rate hikes, the performance of the economy and financial markets exceeded expectations, offering a sigh of relief after the turbulence of 2022.
However, economic momentum is slowly decelerating across various sectors. Consumers are experiencing the delayed effects of reduced fiscal stimulus and persistent inflation, draining their savings, and prompting them to accrue more debt to uphold their current lifestyles. The personal savings rate has fallen to 4.2% this year, far beneath its long-term average of 8.9%, suggesting a need for increased saving over the next few years. Coupled with the impending restart of student loan payments, these factors are likely to dampen consumer spending in the coming months.
The housing market appears to be stabilizing, albeit at low levels, due to constrained supply and steadying mortgage rates, signaling the worst may be behind us. Overall, the US economy should continue to grow at a tempered pace from here, and while a recession is not guaranteed, a slower moving economy will be increasingly sensitive to shocks.
Inflation, after nearly two years of causing a squeeze on consumer wallets and contributing to a rapid rise in interest rates, now appears to be on a sustained downtrend. Headline CPI (Consumer Price Index) has retreated from a peak of 8.9% last June to a mere 3% a year later. Key components of CPI are experiencing disinflation due to declining energy prices, improved supply chains, and reduced consumer demand for goods. Core services prices outside of housing remain an issue but are expected to decrease over the next year with improved supply chains and a less strained labor market.
Since the outset of 2022, the Fed has hiked rates by a cumulative 5% to counter persistently high inflation. However, in June, they decided to keep the federal funds rate unchanged at a target of 5.00-5.25% for the first time since the tightening cycle began. The Fed’s “dot plot” indicates that the June pause could merely be a skip, as the median FOMC member now expects a year-end federal funds rate of 5.6%, hinting at two more rate hikes this year with no cuts until 2024. This reflects the committee’s concern that elevated inflation may necessitate a highly restrictive monetary policy for a more extended period. While the committee does acknowledge inflation is moving in the right direction, it emphasized the need for more evidence that inflation is under control before declaring the end of the tightening cycle.
The tight labor market has kept the unemployment rate near 50-year lows, currently at 3.5%, notwithstanding cooling demand. Wage growth has moderated from its peak of 5.9% in March of 2022 but is still elevated at 4.4%. Getting inflation back in the bottle without a meaningful increase in the unemployment rate has been the Fed’s goal throughout its hiking cycle but may be difficult to achieve. For example, the “job-finding” rate—which shows how many individuals who were previously unemployed are now able to find a job—has weakened to its lowest level since September 2021. If this rate continues to move lower and jobless claims move higher, we’d expect cracks in the labor market to widen, giving way to weaker and possibly negative payroll growth. However, due to a structurally smaller labor force than prior decades (driven by demographics and immigration), any rise in the unemployment rate may be limited despite businesses curtailing hiring efforts amid slower demand and higher costs.
After enduring a generational period of weakness in 2022 due to the rapid rise of interest rates, bonds are behaving like bonds again and should be considered important ballasts in a multi-asset portfolio. We believe there are still opportunities for both capital appreciation and attractive income generation in bonds—assuming both inflation and interest rates continue to glide lower. Core bonds, as measured by the Bloomberg Aggregate Bond Index, have performed well during Fed rate-hike pauses. Since 1984, core bonds generated average 6-month and 1-year returns of 8% and 13%, respectively, after the Fed stopped raising rates.
Equity markets have had a solid year so far despite economic headwinds, supported by corporate earnings that have exceeded expectations and anticipation of an end to Fed tightening. The first quarter saw S&P 500 operating earnings per share rising 6.4% from the previous year and profit margins expanding to 11.7%. But the heightened risk of a potential recession could put further pressure on profit estimates. This, coupled with expectations for interest rate policy easing that may be too optimistic, creates a challenging backdrop for equities, hence suggesting a defensive stance with a focus on quality and cash flow generation. We recently increased the weighting of the quality factor within our equity strategies to account for the potential of increased economic uncertainty and market volatility.
Stock market performance became “top heavy” in the first half of the year, with gains led by a handful of mega cap technology stocks. Investors flocked to these names for safety during the regional banking turmoil, debt ceiling negotiations, and to participate in the artificial intelligence (AI) investing frenzy. The six largest US stocks accounted for most of the gain in the S&P 500 Index, while the average stock hardly budged. This was evidenced by the 9.9% difference in performance between the S&P 500 Index, which is weighted by market cap, and the S&P 500 Equal Weight Index. This gap is in the 98th percentile historically, suggesting we’ll likely see much broader participation across all stocks and sectors in the back half of the year. Furthermore, value stocks are poised to perform better relative to growth, especially if inflation remains elevated. These trends should provide a favorable backdrop to our equity strategies, which continually seek to identify quality companies that are undervalued and exhibit the characteristics that have led to outperformance over time.
While we anticipate a number of shifting elements in the economy for the remainder of the year from interest rates and inflation to the job market and a potential recession, 2023 has reminded investors of the importance of staying invested despite an uncertain outlook and to be open to outcomes that may not be expected.
As always, please reach out if you have any questions.