To the surprise of many, much like the Little Engine Who Could, the US economy kept chugging along in the second quarter of 2023. With many expecting an imminent recession, the economy continued its slow but steady climb upward. Estimates are that U.S. Real (i.e., inflation-adjusted) Gross Domestic Product (GDP) grew 0.6% (annualized) in the second quarter of 2023. While certainly anemic, this still represents positive growth not only for the quarter, but for the prior four quarters.
Even better economic news is the continued resilience of the U.S. labor market. Despite all the talk of recession and other worries, the Unemployment Rate for May came in at 3.6% with average hourly earnings growing an impressive 4.4% over the prior 12 months. Negotiating power has been shifting significantly to labor in ways that have not been seen in many generations. This is good news for employees but makes it more difficult to bring inflation under control.
While a recession has been avoided so far, nevertheless, the consensus view remains that a recession is coming. Consensus estimates are that it will arrive in the second half of 2023, albeit likely shallow and short. This recessionary view is confirmed by the significant and persistent inversion of the Treasury yield curve, unlike anything seen in decades.
Coupled with that surprising economic resilience, the inflation picture, while still elevated, continues to show signs of improvement. The most current reading came in at 4.0% (12-month Consumer Price Index change, May 2023), down from the recent much higher levels, but still a long way away from the Fed’s target of getting back down to 2.0%.
Against this favorable economic backdrop, equity market investors were rewarded with strong returns in the first half of 2023. This strength persists despite many reasons for worry: the continued conflict in Ukraine, the challenges faced by regional banks, the uncertainties of the commercial office space market, and the mounting U.S. debt burden.
The uppermost topic on investors’ minds these days seems to be the next moves of the Federal Reserve. Despite the Central Bank’s current tight monetary policy (Federal Funds currently at 5.25%), expectations for further rate hikes (to a “terminal rate” of 5.75%), and the Fed’s communicating its resolve to keep rates higher for a sustained period, the markets continue to show expectations that rates will quickly reverse after reaching that terminal rate. The markets may be in for a disappointment!
The global economic picture is similar to that of the U.S.: low growth, slowing, but persistent inflation, and tight monetary conditions. While the U.S. economy and markets have been the recent front runners, international and emerging markets show attractive valuation discounts, favorable demographics, and growth prospects. So, U.S.-based investors should be sure that they have adequate global exposure in their investment portfolios to capitalize on these opportunities.
For the remainder of the year, investors should keep close watch on economic conditions given the inflection point it seems to have reached. The economy could continue to slog ahead or possibly, finally slip into a recession. The labor market could remain well supported or layoffs could pick up. Inflation could continue to trend lower or persist as it gets baked into expectations. Therefore, investors must be particularly diligent in maintaining their investment strategy’s alignment with their financial goals . . . being resolute to make investment decisions with their minds rather than their hearts!
During the 2nd quarter, the stock market experienced mixed performance. The S&P 500 demonstrated robust performance exhibiting strong gains and reaching new record highs with a total return of 8.74%. Investors were optimistic about the economic recovery, fueled by government stimulus measures and positive corporate earnings. The S&P 400 Mid-Cap and the S&P 600 Small Cap indexes faced more headwinds with fluctuations influenced by factors such as inflation concerns and regulatory changes. Despite some ups and downs, both indexes managed to end the quarter with modest gains of 4.84% and 3.36%, respectively. As for the S&P International 700 Index, it exhibited a somewhat different trend by starting the quarter as the leader but finished with a positive performance of 3.40%, which was in line with the US small cap market.
Over the past 12 months, the stock market witnessed a generally positive trajectory across all the major equity indexes. The S&P 500 experienced significant growth during this period, reflecting a strong rebound from the bear market of 2022, turning in a one-year number of 19.56%. Similarly, the S&P 400 and S&P 600, representing mid-cap and small-cap companies, also enjoyed overall gains. The S&P 400 Mid-Cap index posted a one-year return of 17.53% and strongly outpaced the S&P 600 Small Cap index, which only returned 9.67% during the same time frame. These indexes benefited from the broader market rally, driven by optimism about economic recovery and hopes that if a recession actually comes this year, it will be a relatively “soft landing.” As for the S&P International 700 index, it followed a similar pattern, but with variations influenced by regional economic factors and geopolitical events to give a strong 12-month return of 16.67%. Overall, the past 12 months exhibited positive market sentiment even while facing continued headwinds of rising interest rates and inflation numbers not falling as fast as the markets had hoped. There seems to be a debate between those that think we are in a “bear market bounce” and those that think we have just kicked off the next “bull market.” We do not see that debate ending soon. We believe even though the markets could be higher 6 to 12 months from now, there is always a chance of a 10% correction as part of a market in an upward trend.
Inflation rose to 0.4% (month-over-month) in April, in line with expectations of 0.40%, and fell to 0.10% (month-over-month) in May. The expectation for the month-over-month number in June rose to 0.30% and was released on July 12th and rose only 0.20%. If we can see month-over-month numbers stay in the 0.0% to 0.20% territory for the next several months, then the CPI year-over-year number will come back towards the 2.5% level over the next 12 months.
GDP growth came in weaker than the initial expectation of +1.8% for the 1st quarter, with an actual +1.1% for the quarter in the Advance Release but came in slightly higher with the Third revision at 2.0%. The debate among economists and market pundits continued during the 2nd quarter as to “when will the recession end” even though there has been no definite proclamation of a recession yet. We still believe it is highly likely we will hear that announcement sometime by the end of 2023 or early 2024.
The Unemployment rate ticked down to 3.4% in April after dropping to 3.5% in March. We saw an increase in May to 3.7% and a subsequent drop back to 3.6% in June. We could see unemployment start to rise in the 3rd quarter of 2023 as the economy slows and layoffs increase; however, with so many jobs still open and unfilled in the US, it may take some time before those laid off add to the unemployment rolls.
Nonfarm Payrolls continue to have solid monthly numbers and may remain strong in the face of a potential recession as those that are laid off in the coming months may be able to fill some of the 9 million job openings in the US. If the employment picture remains this robust in the face of rising interest rates, the Federal Reserve will not be inclined to curb their enthusiasm for higher interest rates as they seem to want to see unemployment rise to 5 or 6%.
The Federal Open Market Committee raised the Federal Funds rate by 0.25% in May as expected but chose to leave rates unchanged at their June FOMC meeting. The ‘pause’ or the ‘skip’ was mainly due to the slowing economy and the banking crisis that came to light during the last month of the 1st quarter. Based on Chair Powell’s recent comments, we should expect a rate hike of 0.25% at the July meeting and possibly even at the September meeting with a potential terminal rate of 5.75%. As the Federal Reserve was late to start raising interest rates, it is highly likely they will raise interest rates too high causing unnecessary damage to the economy and the banking sector in their efforts to bring inflation down.
—Matt Melott, Manager
— Jacob Chandler, Manager
Yields Reverse Course - The yield curve rose across the spectrum after falling during the first quarter bringing a pullback to the fixed income markets. Interest rates for the 1 month to 30 yr. maturities all went up in the 2nd quarter, as the Federal Reserve hinted at continued rate increases after the “pause” at their most recent FOMC Meeting in June and the looming expected recession.
As of the end of the 2nd quarter, the 1-year US Treasury yield increased from 4.619% to 5.416% (a 79 bps increase) vs the 10-year US Treasury which rose by 37 bps from 3.47% to 3.84%.
The 2-year U.S. Treasury yield increased from 4.027% to 4.9%, the 5-year yield went up from 3.576% to 4.156% (an increase of 58 bps) and the 30-year treasury increased from 3.651% to finish the quarter at 3.862% (an increase of 21 bps).
The probability of a recession is still high as the economy is slowing but with strong employment numbers and consumer spending, a recession is still avoidable if the Federal Reserve will not push their rate increase process too far.
The May CPI month-over-month reading was 0.1%, which aligned with expectations. Year-over-year inflation has fallen from over 8% in the previous quarter to 4.0% and will likely fall more as outsized readings in May and June 2022 drop off. However, inflation will likely pick up again towards the end of the summer or at least will remain well above the Federal Reserve’s 2.0% target. Based on this and Chair Powell’s recent comments, we should expect more rate increases this year, with a terminal rate now above 5.5%. We will continue to closely monitor monthly inflation readings and the Fed’s response as this will undoubtedly impact capital market returns and volatility in the months and years ahead.
The final first quarter GDP figure was raised to 2.0% from 1.3%. Although this was stronger than expected, we are in a trend of slowing growth which could get worse, especially if personal consumption, business investment, and home building continue to slow/decline going into 2023. In addition, the yield curve remains heavily inverted (which generally occurs leading up to a recession) and the Conference Board’s leading index has never declined this much in six months without a recession. With inflation still running hot and the labor market remaining strong, the Fed will likely keep rates high to try to bring down inflation. Therefore, the odds of a recession occurring over the next few quarters have greatly increased. We will continue to keep a close eye on growth figures going forward.
As we are heading into 2023, there are signs that earnings are starting to fall. Indeed, 1Q2023 profits fell the most since 4Q2020. We expect profits to continue to fall, particularly given the impact of higher interest rates and potentially slowing consumer demand. We will continue to keep a close eye on corporate earnings as this will impact equity performance going into 2023.
The global capital markets face several geopolitical risks in the coming three to six months, which could significantly impact investor sentiment and market stability. One key concern is the ongoing trade tensions between major economies, such as the United States and China, as well as uncertainties surrounding Brexit and trade agreements among other nations. These disputes could lead to increased tariffs, disruptions in supply chains, and reduced international trade, ultimately affecting the profitability of multinational companies and causing market volatility. Additionally, political unrest, civil conflicts, and potential changes in leadership in various regions can introduce instability and raise concerns about the business environment. Heightened geopolitical risks may result in increased market uncertainty, fluctuations in stock prices, and the need for investors to closely monitor global developments and assess their potential impacts.
The markets are showing signs that the Bear Market may have entered hibernation, as we started the year with two positive quarters in a row. Although we are glad to see another positive quarter, we may have several more months before everyone is convinced that the new bull market has begun. As we are still facing the same headwinds from the last couple of years – inflation, rising interest rates, war in Ukraine, and slower economic growth – we need to remain patient and focused on long-term opportunities.
Whatever may come, our Lord is still in control. We remain thankful for the provision, protection, and blessings that we received from our Heavenly Father and are looking expectantly to what God has in store for the remainder of 2023.
We are thankful for each of you for bringing Glory and Honor to our Heavenly Father and our Savior Jesus Christ as you serve your clients through Biblically Responsible Investing.
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