Mild recession expected in second half of 2023
10-year Treasury yields are headed lower
Equity markets perform well after the Fed’s final rate hike
Start me up! This iconic Rolling Stones song keeps racing through our minds as we glance across the investing landscape. Why? Because it feels like the drivers of this turbulent market – Federal Reserve (Fed) tightening, inflation, recession worries, geopolitical fears – will never stop. They seem to have more staying power than Stones lead singer Mick Jagger (who turns 80 in July). After last year’s volatile markets and the scare from the recent banking crisis, investors are seeking some emotional rescue. But time is on our side. We believe that we are nearing the end of the equity bear market, peak yields, and Fed hawkishness. This should be welcome news for investors, particularly as we expect the current volatility to lead to robust performance for most asset classes over the long term. We reach into the Stones’ impressive song list to make the case for our more optimistic market and economic outlook.
‘Wild Horses’ of consumer spending are tiring | The U.S. economy remains resilient, supported by consumer spending which continues to expand at a healthy clip. But three factors – dwindling excess savings, higher interest rates and softening job creation – suggest consumption should start to slow. While over 1 million new jobs have been added this year, economic undertones suggest that employment gains are starting to fade. For example, withholding tax collections (one of our favourite indicators) are slowing, tech companies (i.e., Amazon, Meta, Google) are shedding employees, layoff announcements are broadening (i.e., GM, Walmart, Disney) and job openings are easing. In fact, higher unemployment and slower consumer spending are key reasons why our economist expects a mild recession this year.
The Fed ‘Can’t Get No Satisfaction’… until recently | While inflation pressures are gradually easing, inflation is not decelerating fast enough for policymakers. This will likely lead the Fed to raise the fed funds rate to 5.25% at its May Federal Open Market Committee (FOMC) meeting. Since monetary policy acts with a lag of approximately one year, most parts of the economy are just starting to feel the impact of the Fed’s rate increases from about a year ago. As we progress through 2023, the cumulative impact of the Fed’s past rate increases will crimp both capital spending and consumer spending. This, combined with tightening credit standards, are another reason why our economist expects a mild recession to unfold in the second half of the year.
Income investors can ‘Get What They Want’ | Fixed income investors have complained for decades that you can’t always get what you want when it comes to higher interest rates and meaningful income. But with interest rates soaring to levels not seen since 2008, the script for bonds has flipped. Investors can now enjoy attractive yields, without having to stretch for yield in lower quality credits. However, this higher interest rate opportunity probably won’t last long. Slowing growth and decelerating inflation should drive the 10-year Treasury yield toward 3.0% by year end. We continue to favour Treasuries, munis, investment grade, and emerging market bonds. We remain cautious on high yield bonds as their spreads aren’t compensating investors for the threat of a recession.
Equity markets want the Fed and inflation to ‘Get Off Of Their Cloud’ | Equities have historically rallied after the Fed concludes its tightening cycle, inflation peaks and interest rates fall. Assuming the Fed doesn’t over tighten and take the economy into a severe recession, S&P 500 earnings should remain solid at around $215. In fact, the economy’s better-than-expected start this year gives us more confidence in the upside potential of our earnings forecast. The weaker dollar, improving supply chains, and easing commodity and labour costs should also help support margins. These factors should help the S&P 500 move higher toward our 4,400 year-end forecast. We continue to favour Technology, Health Care, Energy and Financials.
International equities caught in a ‘Crossfire Hurricane’ | Europe has successfully navigated its energy crisis, thanks to a warm winter and its unprecedented shift away from Russian natural gas. But its recovery must now survive tighter monetary policy as European Central Bank hawks focus on stubbornly elevated inflation and a tight labour market. Higher rates, tightening lending standards and a housing downturn may expose financial vulnerabilities, particularly for consumers geared to shorter-term mortgages. While Europe and the U.S. will likely experience a recession, history suggests American companies are more adept at navigating slowdowns. Therefore, we prefer the U.S. over international developed markets. Emerging market equities remain attractive as China has not yet felt the full boost from its much-touted post-COVID reopening, but the potential for robust growth still exists. If oil reaches our $90/barrel year-end target, Latin American equity indices should also benefit.
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