The economy is better than expected, but recession risk remains
Overall, the U.S. economy should continue to grow at a tempered pace from here, and while a recession is not guaranteed, a slower-moving economy will be increasingly sensitive to shocks. There remain risks on the horizon, most notably weakness in commercial real estate, that could push this slow-moving economy into a recession within the next year.
The labor market indicates entering into a recession
Overall, cooling demand for labor suggests that job growth should decelerate in the coming months. Indeed, it may even turn negative, which would signal the economy is likely entering into a recession.
Unemployment may rise slightly
As such, the unemployment rate may only nudge slightly higher in the year ahead despite businesses reeling back hiring efforts in the face of slower demand and higher costs. However, wage growth should continue to decelerate and help give the Federal Reserve (Fed) confidence that inflation is sustainably coming down.
Inflation is to be more manageable levels
Improved supply chains and easing labor market tightness should allow this measure of inflation to come down over the next year.
While inflation may not be falling as fast as the Fed would like, it is gradually falling to much more manageable levels. CPI inflation may decline to 3.5% year-over-year by the end of this year and towards 2-3% by the end of 2024, even without a U.S. recession.
Risks to S&P 500 earnings remain to the downside
Despite economic headwinds, equity markets have had a solid year so far, supported by a better-than-expected 1Q23 earnings season and expectations for a forthcoming end to Fed tightening. S&P 500 operating earnings-per-share rose 6.4% from a year earlier and 4.3% from the fourth quarter. Profit margins also rose to 11.7%, indicating that companies have had success in defending margins. However, with heightened risk of recession in the coming year, profit estimates should come under further pressure.
At the current juncture, it is difficult to be overly bullish in equities. While performance this year has been better, it has been entirely driven by valuation expansion on the back of lower interest rate expectations. Expectations for policy easing may also be too optimistic and as expectations adjust, multiples could come under further pressure. Along with slowing growth weighing on earnings expectations, this creates a challenging backdrop for equities ahead. As such, we prefer a defensive stance in equities with a focus on quality and cash flow generation.
The Federal Reserve is nearing the end of its tightening cycle
Since the beginning of 2022, the Fed has hiked rates by a cumulative 5.00% in an attempt to combat persistent and high inflation. At their June meeting, the Fed voted to leave the federal funds rate unchanged at a target rate of 5.00-5.25% for the first time since tightening began. While this move was widely telegraphed, forward guidance was decidedly hawkish.
The median FOMC member now expects a year-end federal funds rate of 5.6%, implying two more rate hikes this year with no cuts until 2024. The committee also increased their forecast for rates in 2024 and 2025, reflecting the committee’s concern that elevated inflation may warrant highly restrictive monetary policy for longer.
Global economic momentum outside of the U.S. remains strong
In China, the lifting of COVID restrictions has allowed for a rebound in consumption after three years of sheltered activities. Travel and leisure spending have bounced back strongly, but a rebound in other services and goods spending remains dependent on a recovery in private business and consumer confidence, which has so far been tepid.
Still, China’s recovery will act as a strong tailwind for its trading partners and tourist destinations across Europe and Asia. As such, divergent paths of growth across the global economy are beginning to emerge with the U.S. slowing while Europe, China and broader Asia accelerate.
A new cycle of dollar weakness may be taking hold
A long cycle of U.S. dollar strength is likely coming to an end. After reaching a 20-year high last September, the dollar had fallen by roughly 10% through late June. The forces that contributed to a rising dollar last year have now receded, potentially paving the way for a new cycle of dollar weakness.
Over the long run, the economy might force to gradually drive the dollar down. In the near term, narrowing growth and interest rate differentials should prevent any sustained periods of appreciation. However, the dollar remains a safe-haven asset and could see bouts of strong performance during periods of uncertainty.
Despite this year’s rally, valuations still present long-run opportunities
In the wake of last year’s broad market sell-off, lower valuations presented investors with a new slate of opportunities across asset classes. While markets have recovered from their lows, current valuations still look more attractive compared to lofty levels at the end of 2021.
Fixed income continues to look attractive as U.S. Treasuries, core bonds and municipal bonds remain below their average valuation levels. International equities, in particular, are being offered at a historical discount while some areas of the U.S. market, specifically large cap and growth, look slightly expensive after strong performance in the second quarter.
Within equities, investors may want to lean into international markets and focus on finding attractively valued companies poised to drive long-run returns. Moreover, the current opportunity presented in fixed income could pass rather quickly once the Fed begins lowering rates, and investors would be well served to take advantage of current yields.
