We offer the following economic and market commentary for the second quarter of 2023.
The delayed effects of monetary tightening and tighter credit availability should dampen U.S. economic growth going forward. However, the enduring strength of the labor market has shifted the expected start of the economic downturn closer to the end of this year or perhaps later. The peak-to-trough decline could be a modest 0.7%.
Congress passed legislation suspending the debt ceiling through the end of 2024, avoiding what would have been the first default in U.S. history. The financial sector has also avoided contagion that would trigger widespread instability in the banking system during the second quarter.
Data releases over the past month have revealed a still-strong economy not yet on the brink of recession. As of June, the labor market registered a 15-month streak of better-than-expected payroll gains. While small business hiring plans are trending down, the descent has been gradual and hiring plans have remained historically elevated.
There was a recent 0.5% jump in real consumer spending. Upward revisions to forecasts for payrolls and disposable income have pushed up expectations for consumer spending through the end of the year.
As the tight labor market has continued to boost real incomes and fuel spending, price pressures have eased gradually. As a result, slightly higher inflation could occur with the increase in the Personal Consumption Deflator (the Fed’s preferred gauge of inflation) averaging 4.5% in 2023.
Nonresidential investment has been bolstered by an influx of new projects in electric vehicle and semiconductor manufacturing; however, a tough environment for commercial real estate would weigh on nonresidential investment in the quarters ahead. More broadly speaking, higher costs and lower business earnings in recent months would put downward pressure on investment spending throughout the economy.
The U.S. economy showed fresh signs of cooling, with a reading of supplier inflation moderating and applications for unemployment benefits rising. U.S. economic growth slipped in the first quarter and consumer spending stagnated in April and May. Additionally, the cash stockpiles that consumers accumulated over the past few years have gradually been eroded. Real personal consumption expenditures could decelerate in coming months, which will pull headline GDP growth lower. The Fed’s expected tightening in July will exert further headwinds on the economy.
Weaker economic growth should soon begin to weigh on hiring intentions – putting upward pressure on the unemployment rate. The unemployment rate should rise by more than 1 percentage point by mid-2024, reaching a peak of 4.6%, before gradually moving back to its long-run average of 4%.
Inflation has slowed from its multi-decade highs, though more recent data has shown some stalling in the disinflationary process. The fed funds rate should reach 5.25% in Q2-2023 and remain at that level through the fourth quarter of 2023. As higher rates cool demand-side pressures and inflation moves meaningfully back towards 2%, the Fed would cut interest rates back to a level more consistent with its neutral (2.5%) rate.
As such, the U.S. economy is likely to slip into a modest recession towards the end of this year, but it is expected to be shallow and short lived.
June’s equity wins around the world added to what has already been a successful year for shareholders. The resolution of the debt ceiling standoff and the Federal Reserve standing pat with their interest hiking cycle in June were macro wins that the market liked despite softening corporate profits. Investor frenzy surrounding all things artificial intelligence continued to express itself in the strong leadership and multiple expansion for those companies deemed to be beneficiaries of the mainstreaming of this new technology.
Stocks gained more ground as the first half came to a close. The broad U.S. equity indexes finished June on a positive note and for the quarter the large-cap S&P 500 posted an 8.7% return, the Russell Midcap was up 4.7%, and the small-cap Russell 2000 gained 5.2%.
Growth stocks slightly outpaced Value stocks in June resuming their recent performance dominance and for the full quarter posted a 12.5% return for the Russell 3000 Growth Index and just 4.0% for the Russell 3000 Value Index. Q2 large, mid, and small-cap Growth stocks dramatically outpaced their Value counterparts. Most of the Growth Leadership, and frankly return for the overall market has been driven by a handful of mega cap stocks including Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, NVDIA, and Tesla. While their profits have grown, investor enthusiasm has driven these stock prices to very expanded price earnings multiples making other parts of the market look much more reasonably priced or downright cheap.
International equities also posted positive returns for June and Q2 except for China which lost almost 10% for the quarter. Returns were significantly lower for international and emerging markets equities than U.S. equities. In Q2, the MSCI All Country World Index ex-U.S. was up 2.4%, the MSCI European, Australian, and Far East Index was up 3.0%, and the MSCI Emerging Markets Index was up 0.90%.
The bond market was faced with the headwinds of rising interest rates and concerns about the stickiness of core inflation and the increasing probability that interest rates will stay higher for longer. The Bloomberg U.S. Aggregate Index was down 0.4% in June and down 0.8% for Q2, the High Yield Index gained 1.7% in June and 1.8% for Q2 while the Global Aggregate ex-U.S. was up 0.3% in June but down 2.2% for all of Q2.
The outlook for stock returns remains uncertain given the slowly deteriorating dynamics of the economy, the higher trajectory of interest rates, and negative impact on corporate profits. It seems likely that the U.S. is headed into a period of slower economic growth if not an outright recession. A recession appears to be the price that will need to be paid for the Fed to crack the strong inflationary impulse in the U.S. That recession is likely to result in lower consumer and business demand and hence higher unemployment. To date, however, the equity market has been looking past this well telegraphed recession to a period of falling interest rates and better corporate profit performance.
However, the outlook for bonds has brightened since last quarter largely due to the likelihood that the Fed is closer to the end of its rate hiking cycle, inflation is coming down, and now bonds actually offer a respectable coupon rate after years of ultra-low interest rates.
There continue to be downside risks to the capital markets which should be kept in mind as 2023 progresses. Those risks include the Fed possibly overshooting their rate increases, a deeper than-expected recession occurs, more stress in the banking system emerges due to the industry’s deposit level declines, an increase in credit defaults as the economy slows, and a possible escalation in the conflict in Ukraine with its potential impact on the prices of oil and commodities.
A longer-term view of markets suggests the tailwinds stock and bond investors enjoyed for the past decade or more including massive fiscal stimulus as well as declining and ultra-low interest rates will not resurface any time soon. Securities’ values are more likely to be driven by the organic operational successes of businesses, and not help from the federal government, speculators, or the use of leverage. That will likely result in market returns being lower than in the recent past.
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Based on the S&P 500 trailing twelve-month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a June reading at the 25th percentile (data series from January 1957 to June 2023.)
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity in May registers at the 53rd percentile (data series from April 1979 to May 2023.)
The equity valuation and economic activity gauges have been reviewed by GW & Wade and are consistent with the firm’s near-term outlook.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well-established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
The information provided above is general in nature and is not intended to represent specific investment or professional advice. No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from GW & Wade, LLC, which can only be provided through a formal advisory relationship.
This outlook contains forward-looking statements, predictions, and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.
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About the indices presented above:
Standard & Poor's 500 (S&P 500®) Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the Nasdaq.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
The MSCI ACWI (All Country World Index) is a market capitalization-weighted index designed to provide a broad measure of equity-market performance throughout the world.
The MSCI EAFE Index is an equity index that captures large and mid-cap representation across Developed Markets countries around the world, excluding the US and Canada.
The MSCI Emerging Markets Index (EM) captures large and mid-cap representation across 24 Emerging Markets (EM) countries.
The Bloomberg Barclays Global Aggregate Bond Index measures global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
The Bloomberg Barclays US Aggregate Bond Index measures the performance of the U.S. investment-grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed-income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than 1 year.
The Bloomberg Barclays US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
The charts are for illustrative purposes and are not indicative of any actual investment. Investments cannot be made directly in an index. The index returns represented in the article above are provided gross of fees. Advisory fees, compounded over a period of years, will reduce the total value of a client’s portfolio. For most clients, GW & Wade assesses advisory fees on a quarterly basis in arrears and deducts the fees directly from a client’s account. To the extent that such fees are deducted on a quarterly basis, the compounding effect will increase the impact of such fees by an amount related to the account’s performance.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. GW & Wade assumes no duty to update any of the information presented above. Clients of the firm who have specific questions should contact their GW & Wade Counselor. All other inquiries, including a potential advisory relationship with GW & Wade, should be directed to: