The economic backdrop thus far in 2023 has proven more resilient than expected. This is especially true as the consensus largely predicted that the U.S. economy would enter a recession heading into 2023 amidst a tightening monetary policy backdrop designed to battle inflation through higher interest rates and higher unemployment. The perception of recession produced an overwhelming deterioration in sentiment tied to equity market participation and an overall bearish outlook toward consumption, economic growth, corporate earnings, and labor markets. In fact, our own ‘View of 2023’ indicated an objective assessment of a slowdown, tied primarily to historical monetary policy actions, while acknowledging the strength of the labor market and the consumer as a potential hedge to a hard landing.
The reality has proven notably different as investors, consumers, workers, and the Federal Reserve all have reason to be satisfied with current data and economic trends. The S&P 500 has returned over 20% year to date (albeit concentrated), economic growth has surprised to the upside, corporate earnings are outpacing estimates, unemployment remains low by historical standards, and the disinflationary trend is intact. While we continue to foresee a tight Federal Reserve throughout this year, higher interest rates have not inflicted pain on the U.S. economy or markets to the extent feared entering 2023. As a result of the updated data backdrop, our view is that the prospect of a soft landing has increased and that a potential recession, likely in 2024, may be mild given the absence of systemic and prudential risks to the economy.
Second-quarter gross domestic product growth (GDP) provided tangible evidence that economic activity accelerated from the first quarter, surprising expectations of a slowdown. GDP rose at a 2.4% annualized rate, significantly outpacing expectations of roughly 1.8%. The composition of growth was encouraging, with solid gains in personal consumption (Chart 1 on the following page), demonstrating resilience among consumers who continue to benefit from positive job growth and rising real incomes despite the Federal Reserve’s restrictive monetary policy stance. While GDP growth may decelerate in coming quarters, the economy will likely avoid recession this year given the fiscal health of consumers and their willingness to spend. It’s also important to note that various sectors of the economy have already exhibited their own versions of a business cycle downside (i.e., recession) and are now on the recovery upswing. The manufacturing sector is a working example of such a phenomenon.
With nearly 85% of S&P 500 constituents reporting in the second quarter, the U.S. large-cap index is on track to modestly beat revenue and earnings per share (EPS) estimates. Through August 4th, positive surprises have handily beaten their long-term averages, with 57% of companies surprising on revenue and 80% of companies surprising on earnings per share. This follows a better-than-expected first quarter earnings season, where earnings declined 3.1% year over year versus the pre-season forecast for an 8.1% decline. Thus, U.S. large-cap companies’ earnings recession has been lighter than expected so far. This resilient earnings backdrop has increased sentiment toward next year’s earnings estimates, with 12-month EPS revision momentum turning positive in late July. Given that equity markets are a leading indicator, it may provide a signal for further upside or perhaps a muted downside potential.
While the latest labor market data continues to showcase the resilience of the economy and the sustained demand backdrop for labor, signs of a steadily normalizing labor market are evident. According to the June Job Opening and Labor Turnover Survey (JOLTS), job openings fell to 9.6 million, highlighting that excess demand for labor continues to normalize from the March 2022 peak of 12 million. Despite this decline in aggregate openings, the economy offers 1.6 open jobs for every unemployed person, significantly higher than the pre-pandemic average (Chart 2). Moreover, the unemployment rate stands at 3.5%, with jobless claims relatively low by historical standards.
Trends in wages likewise provide assurance that the labor market is easing. The second-quarter Employment Cost Index, the Fed’s preferred measure of wages, showed softer wage growth of 4.5% year over year, down from the peak of 5.1% in mid-2022. In sum, the labor market remains resilient yet displays signs of normalization, providing a disinflationary impulse to one of the stickiest components of inflation, which is likely to continue easing throughout the coming quarters.
Trends in inflation data have been positive, with June’s weak headline and core inflation readings continuing the trend of disinflation within the U.S. economy. Headline inflation rose 3% year over year while core inflation rose 4.5% year over year, both below consensus median forecasts (Chart 3). While the headline figure was largely explained by base effects within energy prices, the core figure was positively affected by deflation within core goods prices and slower growth within core services, continuing a declining trend within shelter. Likewise, the Core Personal Consumption Expenditure (PCE) deflator, the Fed’s preferred inflation gauge, is trending downwards, which is likely to continue gradually over the coming months. Given falling inflation and resilient employment, the Federal Open Market Committee is likely near the end of its rate hiking cycle, with expectations for an extended pause at restrictive levels.
The backdrop of sustained economic growth coupled with a resilient labor market and downward-trending disinflation supports the notion that the eventual recession may likely be delayed into 2024. An argument could be made for a full dismissal of a recession, yet that would be uncharacteristic of the long-term business cycle. In our view, continued economic surprises support the notion of a soft landing and provide evidence that the probability of a hard landing may be only a marginal tail risk. Evidence to such a potential outcome will be tied to corporate earnings, inflation releases, and labor market conditions, all of which will likely drive sentiment within equity markets in the second half of this year. It’s also important to stress that the improving earnings sentiment for 2024, coupled with better-than-expected EPS results through the first half of 2023, provides support for sustained equity market participation. As it relates to fixed-income investments (i.e., bonds), the biggest drivers of U.S. Treasury yields will likely continue to be dominated by inflation and economic growth as well as the implications for future Fed policy. Against this backdrop, investors should utilize fixed income to achieve the desired investment objective and should be positioned primarily within investment-grade markets in a balanced approach between interest rate sensitivity and long-term total return objectives. We want to reiterate our view that the risks within the bond market remain far greater than the risks tied to equity market participation. This stance echoes our view from January 2022.
Risks to our View
The soft-landing scenario represents a positive outcome for the U.S. economy and global capital markets. The largest risk to our view centers around inflation surprises to the upside and the downside. Inflation could prove stickier than expected, requiring further rate hikes from the Federal Open Market Committee. Likewise, markets may be underestimating China’s deflationary impact on the global economy and the resulting deceleration in global growth. Unforeseen geopolitical tensions, as well as some exogenous shock to the real economy, could tip the U.S. into recession. Lastly, we are monitoring credit conditions, as the Federal Reserve’s latest Senior Loan Officer Opinion Survey showed that credit conditions are tightening and demand for credit is weakening, which may begin to impact economic growth.
Investment advice offered through CX Institutional, a registered investment advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted.
All return data sourced from Bloomberg.
All other data sourced from Bloomberg, through the release of figures from the Bureau of Economic Analysis, Bureau of Labor Statistics, and from the Federal Reserve and any of its affiliated regional locations.