2023 Mid-Year Macroeconomic Outlook

Introduction

Understanding macroeconomic conditions can help investors better position their portfolios for optimal growth. Even if you consider yourself a buy-and-hold type of investor, having a strong understanding of where we are in the economic cycle can help you weather market declines and make more informed investment decisions. This week I want to provide a perspective on the current macroeconomic conditions and some scenarios on where we might go from here.

Where we stand

After the fastest interest-rate hiking cycle since the early 1980’s, and inflation data cooling, many Wall Street economists believe the Federal Reserve’s tightening phase may be nearly over, with the next potential increase of .25% being the final one, taking the peak federal funds rate to 5.25% - 5.5%.

However, Fed Chairman Jerome Powell is holding back on signaling that may be the case, staying tight-lipped on future hikes until further data comes in on inflation and unemployment. In a note to clients, Michael Gapen, U.S. economist at Bank of America Securities summed it up nicely:

• “The Fed will do what’s necessary to return inflation to 2% over time

• In bringing inflation down, the Fed would prefer not to impose unnecessary damage on the economy

• The Fed will not rule out further action

• Whether the Fed hikes rates again and when it happens will remain data dependent”

Let’s examine some of the current macroeconomic data:

Inflation

Although CPI Inflation dropped from 4% YoY in May to 3% in June, the Fed’s preferred measure, Core PCE index inflation, remains stubbornly at 4.6% as of may, and has hovered at that level all year. The core Personal Consumption Expenditures Price Index excludes food and energy price fluctuations, which makes underlying inflation trends easier to see.

Unemployment

Unemployment has remained at historical lows, with a mild uptick from 3.4% in April to 3.7% in May, and then a slight decline to 3.6% in June.

Labor Market

The broad labor market remains highly employed, even though there have been over 200,000 layoffs in the high-paying tech industry this year (A trend which seems to be slowing).

GDP Growth

Along with strong employment data, GDP growth for the second quarter of 2023 is on track to grow at 2.3% YoY.

Real Estate

People have been predicting (wanting?) the housing market to drop for years, but aside from a brief cooling period last year, 2023 has so far seen climbing home prices once again due to inadequate housing supply and a less-than expected decline in demand from rising interest rates.

The U.S. median sale price is nearly back to its all-time highs of $425,674 after dipping briefly below $400k at the start of the year.

Though there are pockets of rising supply in markets that experienced the highest post-pandemic price increases, national housing supply remains tight. There are currently 1.496M homes listed for sale (a 13.3% decline YoY) and a 28% decline in newly listed homes YoY. Homes are spending a median 29 days on the market before being sold, indicating strong demand.

Overall, home prices have remained steady, despite rising interest rates, with nearly 40% of homes being sold above list price. Only 15.6% of homes are currently being sold with price drops, and an average sale-to-list price ratio of 100.3% (all real-estate data as of June 30th).

Personal Savings Rate

Though still below the pre-pandemic average of about 8.5%, the average US personal savings rate improved from a low of 2.7% last July to 4.6% as of June 30^th .

Consumer Sentiment

The US Index of Consumer Sentiment, which measures household sentiment in personal finances, business conditions, and other areas, has finally shown signs of improvement, up over 40% from its trough in July 2022. However, this measure is also still well below pandemic highs:

Where do we go from here?

Delayed Effects of Rate Hikes

The effects of the fastest period of interest-rate hiking in history could have a delayed effect that may not yet have begun to negatively impact the economy. Former Treasury Secretary Larry Summers proposes that because the Fed underestimated inflation and kept rates too low post-covid, they’re now underestimating the ‘stickiness’ of inflation and how high they’re going to have to maintain rates in order to get inflation down to the 2% target:

J.P. Morgan chief economist Bruce Kasman also presented a more hawkish view on rates, making the following statement: “We do not think inflation is going to come back down to central bank comfort zones by themselves. Yes, there’s a decline going on. But no, we do not think you’re going to get inflation back below 3% in the U.S. or the euro area this year.”

The J.P. Morgan mid-year market outlook also calls out the potential for a, “mild recession near the end of 2023 as the restrictive policy stance from the Federal Reserve creates tighter credit conditions, gradually dragging down growth.” However, JPM expects the recession to be short-lived and shallow, with the Fed beginning a more accommodative rate cycle by Q2 2024.

A Soft Landing

On the other hand, the market seems to be pricing in a soft landing (assuming we’ve already successfully avoided a recession) with Goldman Sachs economists predicting only a 20% chance of a recession in the next 12 months.

Morgan Stanley also raised its U.S. GDP growth forecast from 0.6% to 1.3% in 2023 due to strong industrial sector and public investment in infrastructure projects: "Incoming data now point to a more comfortable soft landing than we had anticipated, led by public investment in infrastructure and nonresidential structures investment," - Morgan Stanley economist Ellen Zentner

Nobel laureate economist, Paul Krugman, recently opined on the latest consumer inflation data, "We haven't touched down on the runway yet, and a soft landing isn't guaranteed," Krugman said. "But it now looks amazingly within reach." It’s important to note that Krugman is assessing the “super core” rate which excludes housing and used car prices and stands at 3.5% over the past year.

Conclusion

Whether we have a soft landing or mild recession, the stock market may be able to benefit from the forward-looking macroeconomic environment for two reasons:

1. A soft landing and sustained growth would be the perfect environment for a steady uptrend in stocks, like the boom times of the 90’s and early 2000’s.

2. A mild recession would likely trigger rate cuts and perhaps even quantitative easing, which has historically lifted markets and asset prices higher, unfortunately, the cost is a wider wealth gap and short-to-medium-term market volatility.

Incoming inflation and employment data will be key to watch in order to predict the Fed’s next move. If future job data continues to show strength (higher wage growth and limited job openings) this may maintain upward pressure on inflation and lead the Fed to maintain higher rates for longer. Conversely, if the delayed effects of their rate hikes so far begin to dampen economic growth and inflation, they may well permanently pause their hikes through the end of the year.

With inflation remaining above the Fed’s long term targets and uncertainty on future rate hikes against a backdrop of extended market growth in the first half of this year (SPY +17% YTD and QQQ +40% YTD), I’m waiting for dips to cautiously deploy my remaining capital as we’ll likely encounter some market volatility into the latter half of the year. Another point of risk to be aware of is the weak market breadth during this year’s market rally:

“The market rally during the first half of the year was relatively narrow, [meaning] that a small number of stocks accounted for most of the equity market returns. Consequently, investors should assess reducing or selling holdings that may have moved "too far, too fast" in the first half of the year.” - Daniel Kern, CFA, CFP

Regardless of what lies ahead, long-term investors could benefit from buying strong, well-run companies at more reasonable valuations than during the euphoria of the liquidity-fed rally of 2021.