We offer the following economic and market commentary for the third quarter of 2023.
This summer’s combination of easing inflation and cooling labor market has fueled optimism that the U.S. economy could be on the cusp of achieving a soft landing, in which interest-rate increases corralled inflation without causing a recession. But soft landings are considered rare because they are tricky to pull off. The goal would face four threats: the Fed holds lengthy high rates, economic growth accelerates, a financial crisis erupts or energy prices rise. With respect to the latter, we are keeping a close eye on the effects of the nascent war in Israel and the continuing war in Ukraine.
Real GDP grew at an annualized rate of 2.1 percent in Q2-2023 due to solid growth in consumer spending and business fixed investment spending. Available data from July and August suggested that real GDP continued to expand in the third quarter.
Solid retail sales—a measure of spending at stores, online, and in restaurants—have contributed to a broad consumer spending surge fueling resilient U.S. economic activity. Job and wage growth remained solid, with people seeking work and earning money. The economy has been on track to expand at around 4.0% annually in the third quarter. With unemployment low, real wages growing, and household net worth hitting another record, American households and consumers should be in a good position. Consumer spending should be close to 4.0% in the third quarter.
Inflationary pressure has eased. The labor market has also become less tight. But some cracks in the economy have started to appear. Households have lowered savings rates and relied on credit card debt to finance strong growth in consumption expenditures. Delinquencies on mortgages, auto loans, and credit cards have recently increased.
There have been increasing hopes that the United States could avoid recession. Three factors would explain why the U.S. economy keeps defying predictions of recession. First, a growing workforce and slower price increases have boosted Americans’ inflation-adjusted incomes this year, fueling more hiring and spending. Second, the unusual nature of the COVID-19 pandemic has distorted spending patterns, leading to shortages of goods, housing, and workers. These conditions created enormous pent-up demand that has been less sensitive, for now, to higher rates.
Third, the government showered the economy with cash and held interest rates at rock-bottom levels, allowing businesses and consumers to lock in lower borrowing costs. Subsequent legislation, including the Inflation Reduction Act and the $53 billion Chips and Science Act, further boosted federal spending, and spurred additional private-sector investment in manufacturing.
None of this would imply the economy will be resilient forever. The Fed raised its benchmark federal funds rate to a 22-year high in July, and officials have kept the door open to further hikes if economic activity should accelerate.
The U.S. economy has shown remarkable resilience, including GDP growth of 2.1% quarter-over-quarter annualized during Q2. Trends in labor markets and consumer spending have remained reasonably encouraging. Finally, while inflation has remained above the Federal Reserve's target for now, enough progress has been made that the peak in the federal funds rate has likely already been reached. Stemming from these trends of ongoing employment growth and receding inflation are important shifts in real household income trends that could be significant for consumer spending and, thus, the overall economy. As paychecks have continued to increase and cost-of-living pressures have diminished, growth in household disposable income has started to outpace growth in consumer spending.
However, while that does offer encouragement for a "soft landing," developments could still unsettle the U.S. economy. With excess savings from the pandemic having been substantially worked through and households perhaps less willing or unable to take on further consumer credit, some factors supporting consumer spending would be less helpful moving forward. More broadly, regional banking sector strains could contribute to reduced lending, the housing sector would face some headwinds, and declining corporate profits could restrain business investment. Finally, the increase could restrain the economy even if interest rates do not rise further. That is especially the case should the Fed maintain its policy rate at an elevated level for an extended time, even as inflation recedes further. A "higher for longer" stance from the Fed could increase real interest rates that would restrain household and business spending.
Overall, there are no clear signals of further rate hikes, but at the same time, it appears the Fed will keep policy interest rates elevated for an extended period. Given that restrictive monetary policy would remain in place for some time, there is still a possibility of U.S. economic recession. That said, the likelihood of recession is getting lower, and the potential economic downturn is getting milder.
With a few exceptions, September and the third quarter saw the global equity markets give back some of the gains earned in the first half of 2023. Bond markets, too, delivered red ink for the quarter except for short-term fixed-income instruments. Markets were responding to the rise in the yield curve and the commitment on the part of the Fed to stay the course, holding interest rates higher for longer. Longer bond maturities were especially hard hit as rates on government bonds maturing in 10 years or more climbed to about 4.7%. By the quarter’s end, the grip of tighter financial conditions showed up in sentiment and consumer behavior.
U.S. stocks across the capitalization and style spectrum delivered modest declines in the third quarter. Small-cap and mid-cap stocks lost more ground than larger company stocks. The S&P 500 was down 3.3%, the Russell Mid Cap Index was down 4.8%, and the index of smaller companies, the Russell 2000, was down 5.1%.
There was a modest reversal of fortunes when comparing Value and Growth style stocks. Unlike earlier in the year, Value stocks lost less ground than Growth stocks in the third quarter. This was a small pullback from some of the extreme valuations given to Growth stocks earlier in the year driven by investor enthusiasm over all things artificial intelligence.
International equities also lost ground in the third quarter. The MSCI All Country World Index ex-U.S. was down 3.8%. There were a couple of notable exceptions, with Indian stocks gaining ground up 2.7% for the quarter and companies in so-called Frontier Markets that were up about 2.0%.
Bond prices across the globe also took a hit from rising interest rates and the prospects of rates being held higher for longer by central banks. With a few notable exceptions, bonds delivered negative returns. The broad Bloomberg Aggregate Bond Index was down 3.2%, the Bloomberg Global Aggregate ex-U.S. was down 4.0%, Bloomberg U.S. T-Bill index was up 1.3%, and even the index for U.S. corporate high-yield bonds (Bloomberg U.S. Corporate High Yield Bond) were up fractionally.
The outlook for stock returns remains uncertain given the slowly deteriorating dynamics of the economy, higher interest rates that are likely to stay at these levels or higher longer than expected, and the negative impact this should have on demand for goods and services in the economy. Downstream, this should continue to impact corporate profits which have been growing more slowly in the past year. The U.S. is likely headed into a period of slower economic growth likely resulting in higher unemployment. The equity markets earlier in the year seem to have been looking past this well-telegraphed slowdown to a period of falling interest rates. But some stock prices, especially those driven by more speculative impulses, may have to adjust to the realities of a less constructive longer-term economic outlook.
However, the longer-term outlook for bonds continues to look pretty bright, mainly due to the likelihood that the Fed is closer to the end of its rate hiking cycle, inflation is coming down, and now bonds offer a respectable coupon rate after years of ultra-low interest rates. Bond coupon rates currently provide real competition for investment dollars versus stocks, given the more expensive investment profile of stocks in general.
There continue to be downside risks to the capital markets, which should be kept in mind as 2023 comes to an end. Those risks include another Congressional budget impasse in November, the Fed possibly overshooting their rate increases, a deeper-than-expected recession occurring, more stress in the banking system emerging due to the industry’s deposit level declines, an increase in credit defaults and household bankruptcies as the economy slows, a possible escalation of the conflict in Ukraine and the war in Israel, with their potential impact on the prices of oil and commodities.
A longer-term view of markets suggests that the tailwinds stock and bond investors enjoyed in recent years, including massive fiscal stimulus and declining and ultra-low interest rates, will not resurface soon to smooth over inevitable hard times. Securities’ values are more likely to be driven by the operational successes of businesses rather than help from the federal government. These conditions should favor active stock and bond selection.
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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.
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