Market Update: Is Improving Optimism Well-Founded?

By Published On: July 25, 2023Categories: Market Commentary3.9 min read

Over the past three months, the economy has held up better than many expected. Rising rates have helped bring inflation down and slow economic activity enough, without heavy job losses or increased stress on the banking system.

In response, many economic forecasters are pushing forecasts for recession further out—perhaps into next year, if it occurs at all. In a recent survey, a strong majority now sees the odds of recession in the US in the next twelve months at less than 50%. Also, financial markets expect the Fed to announce one more rate hike this week and then pause, with rates perhaps starting to fall in spring of next year.

So, the overall mood is more optimistic than it was in March, when several banks failed and investors worried about the health of the financial system. In keeping with that sentiment, stocks have gained momentum. While only a handful of Big Tech stocks drove gains earlier this year[1], we are now seeing a broader base do well—banks, industrials, smaller stocks, etc.

Our Take

Long-term investors recognize that shorter-term economic forecasts evolve and are generally unreliable, and that market swings occur which may not be sustained. We therefore do not recommend changing course in investment strategy on any prevailing mood. Better economic news is encouraging, but there are many puts and takes at play. In our view, success requires a very balanced approach.

We do not make annual economic forecasts, but we do carry observations to help put our decisions in context. Here are our key points in this environment:

  • Rates have risen at their fastest clip in modern history, and yet the economy—evident in a strong labor market, recovering housing market, and moderating inflation—has held up better than most expected.
    • We believe this is due to a few things: namely, that the economy is less sensitive to higher rates than before (homeowners have locked in fixed rate mortgages, for example), and participation rates in the labor market are artificially low following the COVID years.
    • History shows there is a 6-18 month lag in impact from higher rates on economic activity. We are certainly starting to see some impact, but it is unclear if the Fed will have to remain aggressive later this year. Sustained strength in labor and limited supply in housing imply inflation could be sticky, especially if economic activity improves.
  • Bank lending carries a lot of weight on business activity, and lending standards are much tighter currently vs. a year ago. The commercial real estate challenge remains ahead for regional banks. The encouraging news is that the banks are better capitalized today to handle potential defaults and the risk of bad loans is spread out over a few years, providing some time to work out delinquencies if vacant space lingers. We expect tighter lending standards will help cool the economy and perhaps offset the need for more aggressive rate increases.

All-in, we continue to think the signals from the bond market (inverted yield curve) and the leading economic indicators (usually reliable predictors) have it right—that recession is likely at some point on the horizon. In reality, several rate-sensitive sectors already experienced a meaningful downturn in fall of last year, and we expect we might see “rolling recessions” across the services sector in the coming twelve months. The result might not be a synchronized downturn but instead a staggered period of slower pockets of growth

On the sentiment side, we note that retail investors have become more bullish than institutional investors since the banking crisis in March. Retail investors tend to be more volatile in behavior. Notably, retail options activity has surged again, approaching levels last seen during the market surge in late 2021. Similarly, the tech rally this year appears less based on fundamentals and more on momentum and expectations around artificial intelligence. Valuation multiples have expanded even as earnings forecasts have dropped. We have concern that some investors are chasing returns.

There are therefore conflicting signals across financial markets about the state of the economy. On the one hand, more stocks are participating in the rally on relief that recession may not be a 2023 event, and credit spreads (a measure of risk in fixed income) are improving; on the other hand, bond markets continue to predict recession. They also predict that inflation will fall below 3% within a few years.

To navigate what is likely to be a volatile period in financial markets, we continue to recommend a diversified strategy, hedged against various outcomes of growth, recession, and rates.

[1] From January first to end of May, ten tech stocks accounted for 100% of the returns of the S&P 500. This is a very narrow, undiversified group.

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