2023 Q3 Market Outlook
I was fortunate enough to kick off the summer with a trip to a small island out on the Puget Sound, a great place to enjoy the sunshine and cool water. This nice weekend reminded me of why we put up with the nine months of dark and gray and rain; because these summer months make it all worth it!
As we kick off the third quarter, and cross the halfway point in 2023, this is a great pausing point to reflect on what we've seen so far in the first half of 2023 and what we expect for the second half. It has been an amazing start so far in the markets, with the stock market up double-digit percentages, primarily on the back of a possible Fed pause and excitement around AI.
To take a step back and put this in perspective, the reality is we are still down from the highs of late 2021. Looking back to the beginning of 2022, we began to see the market pull back. This pullback was due to expectations of a looming recession. It was the most anticipated “recession” we've ever seen. However, just like the changing of the seasons, we're starting to see signs of a seasonal shift in the markets.
Let’s take a look at the 2023 score board:
Stocks: So far this year, the S&P 500, which represents a broad view of the markets, is up around 15%.
Bonds: The bond aggregate index is up year-to-date just over 2%, and bonds are paying around 4% in interest, depending on the duration.
Commodities: Commodities are a bit stale so far this year, mostly due to oil prices. Year to date, commodities are down about 4%, but it seems likely oil has been hitting a floor at about $67 a barrel.
Cash: When it comes to cash, certain instruments are now paying nearly 5%.
These signs are pointing to what they call a "soft landing". What this soft landing refers to is the Fed’s path on hiking rates and how they may be able to engineer a slowdown of inflation without actually putting the economy into a recession.
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Are we entering a recession in 2023?
As we look to the second half of 2023, the term recession remains in the spotlight. Earlier this year, we shared that we expected a recession in 2023. Although I think the odds of a recession have reduced significantly, and the market is suggesting that it's not going to happen, we still think that it is very possible. Historically, the Fed has been extremely unsuccessful when trying to combat inflation without inducing a recession. To be clear, that doesn't mean it can't be done. But if history tells us anything, it suggests that this idea of a “soft landing” is a much more difficult task than it may seem on the surface.
In fact, there may even be signs of a further slowing economy today. Looking at gross domestic income (GDI), one of the largest factors in how a recession is judged. GDI has been showing signs of cracks and has been negative two quarters in a row. The money supply numbers are also important to pay attention to and M2 money supply has been falling significantly now. However, the jobs market remains strong and is an area of economic hope that continues to conflict with some of the more negative data points. With all that said, we have had a great run, and believe that it is still likely that we are moving into the next iteration of a market cycle. Just like the changing of the seasons, it is a great time to consider a shift in strategy, but to be clear, there are still many potential risks to be cautious of.
Economic risk factors in 2023
Tech Valuations
First, as we unpack these risk factors, we look to tech stocks, which broadly, are valued high again at this moment. The tech sector is the most “expensive” we've seen on a P/E basis over the last ten years, and even higher than the high-flying days of COVID, making it critical to watch. Much of this higher valuation has been driven by the Artificial Intelligence (AI) conversation, which has led to a hope of increases in revenues and profits.
Political Turmoil
Another risk is the political theatrics that are likely ahead. The new dynamic of a split congress has led to gridlock in Washington. When both sides know that nothing will get done, especially during an election year, you can expect a lot of political posturing on both sides of the aisle. We have already seen quite a bit this year with the student loan forgiveness (link), debt ceiling, and more. As we get closer to fall, it is likely finger-pointing will increase again.
Rate Hike Impacts
It is possible we have yet to experience the full impact of the Fed rate hikes. Typically, it is many months after a rate hike before we feel those impacts carry through the system. Looking ahead, the Fed is still raising rates and these most recent hikes may not be felt for another year or more, as these shifts in policy do take time to be felt by our economy. Just like inflation took a while to catch up after the money supply increased and the time it took supply chain issues to work their way through the system after we reopened from COVID, our worldwide economy is so large it doesn’t shift at the drop of a dime.
A Fed Surprise
Lastly, it is important to weigh a possible surprise with the Federal Reserve’s in their upcoming announcements. The Fed has been very clear about its path up to this point and has been cautious about surprising the markets. Do keep in mind, however, that if inflation does persist, the Fed is likely to continue to hike until inflation is tamed, or we move into a recession. It has been very interesting to see the differences when looking closely at the stock market as compared to the bond market, and how the two markets are pricing this risk differently. The stock market appears to be pricing in a soft landing from the Fed and even suggesting the Fed is bluffing about how long they may keep rates higher. The bond market, on the other hand, is telling a different story.
To sum this all up, there are potential risks out there, but it is important to be in a position to take advantage of the growth opportunities that we are seeing this year, too. Balancing these opportunities and risks, it is key to be defensive enough to manage risk effectively in the event a cold front still comes through during the spring season. Plus, when cash is paying 5% or so, it pays to wait a little bit for the right opportunities.
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Looking ahead to Q3 and beyond in 2023
As we reach the halfway point, the economic dynamics are starting to shift and require a shift in focus. There are many areas that we are paying close attention to as we move into the second half of 2023.
The first item to consider in equities is a great blend of value and growth stocks. Over the past 18 months, we have discussed a lot about the importance of value stocks. Growth has taken off again in 2023. However, the reality is US quality stocks are one of the top-performing subsectors within the equity asset class. Just as it was in 2022, it will still be important to make sure you own strong companies with strong balance sheets.
Now small-cap (smaller size companies) compared to large-cap (larger size companies such as the big household names we are all familiar with) valuations are extremely low. If markets do continue to rebound, small-cap stocks will be another area to watch closely. Small-cap companies also tend to do very well when markets rebound as we move into a different market cycle.
Bonds are also looking much more favorable. Now that yields are higher, we are being paid much more to hold these assets. Bond prices also have an inverse relationship to interest rates, so if the Fed does reduce rates, bond prices rise. This provides a great risk-reward opportunity with the current higher interest rate environment and as the Fed changes their tone. The challenge we face, however, is that you may risk getting too excited or moving too fast as the Fed keeps raising rates. Due to this risk, it may be wise to dollar cost average in overtime in hopes of finding opportunities at higher rates.
Inflation certainly is starting to slow, but I would suggest that I don't believe we will see any significant decrease in the inflation rates still for some time, which make commodities important to watch. Core inflation is still running near 5% year-over-year and the Fed target is 2%, which is still a big difference between a manageable inflation rate and what we are experiencing today. Just because inflation is beginning to slow, does not mean the prices increases have stopped and certainly does not mean prices are coming down. It just means the rate of growth of those prices has slowed. Commodities still have a role for now as a hedge and potential defensive play in case things do shift.
Lastly, cash is important, at least for the short-term. Short-term cash-like instruments are starting to pay, allowing a more attractive risk-free opportunity to weigh when evaluating how much of your portfolio should be invested. When you are receiving, for example, 5% on your cash instruments, it may allow you to be more cautious before taking on too much risk. This is because you are receiving a much stronger return as compared to when cash was paying nearly nothing. Remember, however, that it does take some time for cash returns to work their way through to experience the full annual return. Cash instruments typically pay out monthly so it will take the full calendar year to recognize the entire 5% return (assuming the rates remained the same). This great risk/reward dynamic allows us to be more thoughtful and more cautious versus getting too aggressive too early and possibly getting caught in what is called a bear trap.
Wrapping up
It certainly seems that we are getting closer to spring or summer months in the markets. We believe that there are a lot of challenges still left to be resolved. However, we are likely getting closer to some warmer days, but there is nothing worse than getting caught in a bear trap which is why we encourage strategic caution. It is a good time to be thoughtful in terms of how much and where you deploy capital into the markets while managing risk along the way. On a high level, using a good blend of growth and value stocks as well as exploring small-cap stocks, and bonds for growth opportunities for income will be key. Using commodities to help hedge and manage persistent inflation and holding onto some cash as an opportunity for a risk-free return will be paramount to managing the risk that may be ahead.