LET’S TALK TO SOME PROS.
Edward Jones’ investment strategists in the following report provide their thoughts on current opportunities and potential risks for the second quarter 2023.
Second Quarter 2023 Economic Outlook
While the economy remained resilient in Q1 and the labor market showed ongoing strength, there may be signs of softening in the quarter ahead.
Higher interest rates and inflation weigh on households and corporate earnings — The Federal Reserve raised interest rates twice in Q1, bringing the federal funds rate to around 5%, its highest level since 2007. These higher interest rates increase the cost of borrowing for consumers and corporations, putting downward pressure on demand broadly. As a result, consumer confidence has moderated, and corporate earnings growth has been revised lower. For 2023, S&P 500 earnings growth is now expected to be around 1%, well below the 10% growth estimate expected mid-2022.
Banking sector turmoil may have ripple effects — While the recent volatility in the banking sector has stabilized, there may be longer-term impacts to economic activity. These may come in the form of banks tightening their lending standards and an increase in regulations focused on regional banks. As banks pull back on potential loans, corporate and consumer spending may moderate as well. Perhaps the silver lining is that tighter credit availability may also move inflation marginally lower, which could support a pause in the Fed’s interest rate-hiking campaign.
We still anticipate a mild recession in 2023 — In our view, a mild economic downturn remains likely and may begin sometime in the second half of 2023. We would expect to see consumption fall and the labor market to soften, although more modestly than in past recessions, with the unemployment rate perhaps remaining below 5%. We continue to see inflation moderating, with core inflation heading toward 3% by year-end. With this backdrop, the Fed is likely to pause hiking interest rates by mid2023, which historically has been beneficial for both stock and bond markets. Past performance is not a guarantee of what will happen in the future.
Recommended action for investors: Action for investors While volatility may increase as an economic downturn emerges, markets are also forward-looking and can start to recover months ahead of a recession’s end. We recommend investors use pullbacks to diversify, rebalance and add quality investments to portfolios, according to their personal financial goals, ahead of a potentially more sustainable recovery.
Second Quarter 2023 Equity Outlook
Markets wrapped up a volatile but positive quarter as strength in tech offset weakness in banks, but the path to recovery could be bumpy in the short term. We think further moderation in inflation and a likely Federal Reserve interest rate pause by early summer can support a positive outlook for the remainder of 2023.
Volatility to stay elevated as growth slows — The economy started Q1 on solid footing, but we expect some softness ahead as the effects of monetary tightening filter through. While we anticipate a modest recession, we don’t expect a deep or prolonged downturn given the solid consumer finances and labor market dynamics. We believe a rebound could materialize in the second half of the year.
Stocks can start looking through the valley — As the economy slows, earnings will likely continue to be under some pressure. But last year’s decline in valuations potentially discounts some of the challenges. Though emerging bull markets don’t follow a timetable, stocks tend to move ahead of the economy and can bottom before economic data and headlines improve.
3 reasons mid-October could have marked the bottom —
1. Even with lingering price pressures, we’re seeing a trend of disinflation. The path lower is unlikely to be a straight line, but even with historic low unemployment, wage pressures have started to moderate.
2. After hiking rates aggressively over the past 12 months, the Fed is nearing the end of its tightening campaign. A Fed pause has historically been a catalyst for improved equity performance.
3. S&P 500 earnings estimates have been cut to about 1% from about 10% a year ago. In our view, this better reflects the expected growth slowdown.
Recommended action for investors: We recommend a neutral allocation to U.S. large caps, with an overweight position in emerging markets and an underweight to small caps. We favor increased allocations within health care and consumer discretionary and reduced allocations to utilities and communication services. Consider dollar-cost averaging to take advantage of the volatility and position portfolios for a more sustainable rebound.
Second Quarter 2023 Fixed-Income Outlook
Government bond yields moved sharply lower in Q1 as the banking crisis unfolded, and investors flocked to safe-haven assets such as Treasury bonds. We would expect yields to stabilize and move somewhat higher in Q2, although the peak in yields for this cycle may be behind us.
A Fed pause is likely on the horizon — We expect the Federal Reserve to pause raising interest rates in mid-2023, especially as economic growth softens and inflation continues to moderate. This would also likely cap an upward move in Treasury yields. Although markets are forecasting multiple rate cuts in 2023, we would not expect the Fed to pivot to lower rates unless inflation was closer to its 2% target or the economy was materially weaker. Inflation is still elevated, and the economy and labor market continue to show signs of resilience. However, the Fed could signal rate cuts toward year-end, as inflation potentially heads toward 3%.
A pause in rate hikes has favored bond returns — Since 1984, the average return for investment-grade bonds from a Fed pause to its first rate cut is about 7%. Notably, in Q1, investment-grade bonds were up about 4%, as yields moved lower late in the quarter and investors sought safe-haven assets during the banking uncertainty. We would expect bonds to continue to offer this diversification benefit in the months ahead, especially during periods of equity market volatility.
Opportunities may be forming for longer-duration bonds — In Q1, investors continued to seek higher-yielding investments in liquid assets, including CDs, money market funds and short-term Treasury bonds. But we see opportunities forming to complement these potentially with longer-duration bonds, particularly in the investment-grade space. These bonds not only lock in yields for longer, but also have the opportunity for price appreciation, especially if the Fed does pause and, over time, move interest rates lower.
Recommended action for investors: We see opportunities forming to complement shorter-duration bonds and CDs with longer duration bonds, especially in the investment-grade space. We recommend working with a financial advisor to ensure your portfolio has adequate fixed income diversification to meet your financial goals.
Second Quarter 2023 International Outlook
Global growth could stay lackluster this year. But China’s reopening, a potentially softening U.S. dollar and still-attractive valuations suggest international diversification could benefit portfolios again this year.
Europe dodges recession, but risks remain — Confidence in Europe has started to recover as a warm winter helped avert a much-feared energy crisis. Natural gas prices have now returned to where they were before the Ukraine invasion. With the help of a strong labor market, the economy grew in Q4 despite expectations for a contraction. Downside risks remain as the rise in borrowing costs likely pressures demand.
China’s reopening provides a boost — After battling a COVID-19 resurgence, China pivoted away from its zero-COVID policy in Q1. This has led to a pickup in factory activity and should release pent-up consumer demand in the coming months. At the same time, the government continues to support growth. As a result, China is the only major country where growth is expected to accelerate from last year.
The global fight against inflation continues — Eurozone inflation appears to have peaked, but core inflation — which excludes food and energy — remains sticky and is higher than in the U.S. Because of this, the European central bank might stop hiking rates after the Federal Reserve does. With the difference between U.S. and European policy rates likely to narrow, the U.S. dollar could weaken, boosting international returns.
International valuations are not stretched, despite recent rally — International equities have outperformed U.S. equities over the past six months and one year. But despite the rally, international equities still trade at a near-record discount relative to U.S. equities. This suggests there is more room for global indexes to make up some ground lost over the past decade.
Recommended action for investors: We recommend an overweight position in emerging-market equities that could benefit from China’s reopening and the potential for a softer U.S. dollar.
LOOKING BACK AT THE FIRST QUARTER 2023
2023 started strong on signs the pressure to global growth might not be as bad as previously feared. But market volatility reappeared as investors weighed the potential economic impact of higher inflation and financial sector concerns, highlighting the value of portfolio diversification.
A rate-hiking pause draws nearer — Inflation concerns initially flared on signals prices may be trending downward more slowly than expected. The Federal Reserve hiked interest rates two more times in the quarter to help prevent elevated inflation from becoming a long-term drag on growth. Price pressures continued easing, and interest rates finished Q1 lower. We may not have seen the final rate hike, but updated Fed projections indicate a pause has drawn nearer, which could provide stronger footing for portfolios.
Financial sector concerns weigh on growth expectations — Turmoil surrounding U.S. regional banks, such as Silicon Valley Bank, and some larger, more global peers triggered uncertainty about the health of the banking industry. While lending conditions are likely to tighten, it may take time before the full impact of the recent banking-related crisis is known. But swift action from key authorities to provide stability, as well as the strength of banks more broadly, boosted confidence and reduced concerns as Q1 ended.
Leadership rotates, but markets remain resilient — Brighter growth expectations supported more economically sensitive segments of the market in Q1 until inflation- and bank-related concerns rotated markets into a more defensive tone. All recommended asset classes ended the quarter higher. Large-cap stocks led equities, while U.S. small-cap stocks lagged. Strong returns from growth-oriented equities, such as technology stocks, helped overcome weakness within financials and energy. Bond values rose as yields fell, offering a buffer against stock market volatility.
Recommended action for investors: Markets are likely to be sensitive to additional news about the banking system, the path of inflation and monetary policy expectations. Work with your financial advisor to identify opportunities to add quality investments at lower prices, potentially enhancing your portfolio’s diversification.
DEBT CEILING SHOWDOWN: A TEMPORARY RISK
With the recent financial shock from the bank crisis, we suspect policymakers will want to avoid a government default. Political standoffs may add anxiety for markets, but we believe that will prove temporary, with sights turning back toward the economy and corporate fundamentals.
Drama, not default — This year, likely sometime this summer, lawmakers will need to raise the U.S. debt ceiling. Despite deep party divides, we believe a deal will ultimately be reached as both sides recognize that a default on U.S. government debt is unacceptable. We suspect a compromise to raise the debt ceiling will be accompanied by a modest cut to future discretionary spending as well as potentially small, targeted increases on certain taxes.
While this debt limit increase simply kicks the can down the road, we expect this outcome because: 1) it’s the most viable move for now because larger budget issues cannot be solved this year, and 2) lawmakers should want to avoid adding a fiscal crisis to an already softening economy. The resiliency and vibrancy of the U.S. economy will enable the U.S. government to carry an elevated debt load with manageable financing costs (interest rates) for some time to come — but not forever. Eventually, more difficult budget decisions will be required, including a combination of taxes and adjustments to both discretionary and nondiscretionary (including Medicare, Medicaid, Social Security) spending.
Markets tend to move on quickly — This frequency means Markets largely look past routine debt limit changes, though contentious political standoffs have spurred temporary adverse reactions. Brinkmanship tactics do pose a risk, but we think the more likely outcome will be some short-term volatility in stocks and bonds as any potential deadline draws closer in the absence of a deal, with markets quickly shifting back to focus on fundamentals, not Washington.
Recommended action for investors: Market volatility in response to debt ceiling showdowns has been short-lived in the past. Even following the 2011 episode, equities rebounded shortly after and Treasury bonds rallied. We would view any debt-ceiling weakness as temporary, and we’d recommend adding to long-term positions on any such Washington-driven pullbacks.
TEXT SOURCES: EDWARDJONES.COM
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