The third quarter of 2023 marked a significant departure from the exceptionally strong performance in the first half of the year. This transformation was prompted by concerns of a potential recession, escalating geopolitical conflicts, and rising interest rates, which began to permeate the collective consciousness of market participants. This quarter is a pivotal moment in a complex and evolving economic landscape, so it’s essential to unpack both the challenges and opportunities that lie ahead.
Key Takeaways
- The US economy has demonstrated greater resilience than expected, leading to a substantial rally in the first half of 2023.
- With inflation on the decline and the economy staying robust, the possibility of achieving a 'soft landing' is becoming clearer.
- However, risks to the optimistic scenario persist, especially concerning interest rates and geopolitical conflicts.
- These risks are not priced in, with equity markets remaining expensive (particularly relative to rates).
Setting the Stage
First, let’s rewind. As of the beginning of the quarter (July 2023), the prevailing consensus was that we were on course for a “soft landing”, successfully containing inflation while evading a broader economic recession. Consequently, the financial markets were euphoric, delivering one of the best first-half performances in recent history, with the S&P 500 up 17% and the NASDAQ up a whopping 39%. The general sentiment was that the market strength would endure.
Throughout the first half of the year, various macroeconomic indicators substantiated this optimism. Real GDP showcased consistent growth, unemployment rates remained at historically low levels, the housing market exhibited resilience in the face of higher mortgage rates, and crucially, there were clear signs that inflation was stabilizing at a lower level.
Furthermore, the US consumer remained robust, underpinned by sustained growth in real wages and the accumulation of surplus savings from the pandemic. This resulted in a strong resurgence in consumer spending.
Looking Forward
While the first half of the year has indeed given us reasons to be optimistic, it’s essential for us, as investors, to look forward. Our task is to make well-informed predictions about the future and then assess whether the market is accurately reflecting those predictions. When a significant disparity arises between our outlook and the market’s expectations, it serves as a yellow flag, an indicator that we should proceed with caution.
At present, we find ourselves in one of those moments. The market is persistently pricing in a strong probability of a ‘soft landing,’ despite the emergence of several risk factors.
A Soft Landing Remains Possible...
The ‘soft landing’ scenario remains a plausible outcome. This is due to the Federal Reserve’s actions over the past eighteen months, which are now showing signs of success as inflation decelerates across various measures.
As a result, the vast majority of central banks globally are expected to implement significant interest rate cuts over the next two years, providing a stimulative effect to the global economy.
Furthermore, after steadily decelerating for the better part of the last two years, both the US consumer and manufacturing sectors are showing signs of stabilization and inflecting upwards:
Lastly, the CHIPS Act and Buy America requirements have generated a substantial backlog in the construction sector. This backlog should offer significant economic support, even if other segments of the economy experience weakness:
...But Risks Remain
While there are numerous reasons for optimism, especially in the long term, it’s crucial to remain mindful of the near-term risks to economic growth that could potentially disrupt the current positive economic momentum.
Higher interest rates pose the most proximate threat to economic growth, with yields on the 10-year treasury touching 5% for the first time in over 15 years. A rate increase of this magnitude can trigger a host of adverse economic effects, including a significant reduction in credit availability, elevated risks to bank balance sheets (e.g., the challenges faced by institutions like Silicon Valley Bank), and a sharp decrease in housing affordability:
It’s also worth noting that the yield curve has been inverted for the longest duration since the 1980’s. This metric possesses a strong historical track record as a leading indicator of recession and while a recession hasn’t materialized, it would be imprudent to dismiss this indicator as unreliable. Note in the exhibit below that recessions (areas shaded red) typically do not commence until after the yield curve has fully reverted to its normal shape.
Additionally, there are several other risks that warrant attention:
- Excess savings that consumers enjoyed over the past 2 years is mostly gone, and spending has recently begun exceeding income – drawing down savings further
- Record fiscal deficits
- The tragedies in Ukraine and Israel risk sparking broader regional conflicts (keep an eye on China/Taiwan as well)
- Student loan payments restarted this month, creating an additional headwind to consumer spending
- Commodity prices in energy and food had been declining for the last 12-18 months, providing a tailwind to the consumer – that trend has now reversed, turning into an expense headwind
While none of these risks guarantee a recession, it is prudent to assign some probability to the possibility that they may evolve into more substantial headwinds to economic growth. This leads us to a fundamental question: Is the market adequately factoring in these risks, or is it turning a blind eye to their potential impact?
Risks? What Risks?
Current consensus expectations call for overall S&P 500 earnings to grow at ~12%/yr for the next two years, driven largely by margin expansion:
With a backdrop of falling inflation (which tends to suppress margins), increasing interest rates, and lower credit availability, these expectations appear unmoored from reality.
Nevertheless, the market is embracing this optimistic outlook at face value while turning a blind eye to the potential pitfalls. The equity risk premium, which represents the additional return investors expect for taking on the risk associated with equities, has reached its lowest point in decades. Said another way, investors are currently receiving relatively meager compensation for owning equities as opposed to fixed income, and they’re certainly not being compensated for the risk being assumed.
Why Does This Matter? The Relationship Between Valuation and Future Returns
Historically speaking, there’s a strong linear relationship between starting equity valuation (x-axis) and actual future returns (y-axis). Put simply, the higher the starting price, the lower the expected future returns. This relationship is often overlooked by today’s market participants because it requires holding a long-term view, but the tradeoff between price paid and expected returns has held strong throughout history. John Hussman of Hussman Funds puts together a great exhibit to illustrate this relationship:
It’s important to emphasize the nuance in this statement. It’s a common misconception that a high starting valuation implies an imminent and sharp decline in the market. However, this isn’t the case. It simply means that when valuations are high, expected returns going forward are likely to be significantly lower than average. Thus the real risk to investors is not one of precipitous decline, but rather structurally lower returns going forward.
There are some puts and takes here. First, “the market” is not a single entity, but is comprised of hundreds of individual securities. Today, the largest seven companies in the index comprise almost 30% of the total market cap and possess and average P/E of 33x – an unprecedented degree of concentration.
As a result, portfolio construction becomes incredibly important in managing risk. Appropriate asset allocation, position sizing, and security selection can help mitigate concentration risk.
It's All Relative
Bond yields are finally at levels that provide adequate returns over the long run, and can thus act as a tool to mitigate the aforementioned concentration and valuation risk in equities. With the state of the fiscal deficit and the potential for even higher rates, the duration of longer-term bonds may not be attractive. However, front end treasuries, structured credit, and high quality corporate credit can all provide strong income and diversification to a portfolio.
In equities, taking a more balanced sector and position sizing approach relative to a highly concentrated, top-heavy market feels appropriate. In terms of stock selection, there are very clear pockets of opportunity in the equity market for the discerning investor.
As with any investment portfolio, the precise asset allocation between equities and bonds depends on each individual’s goals and tolerances – we’re happy to have a conversation about bespoke portfolio customization to meet your needs at any time.
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About Chris Stevenson, CFA®
Mr. Stevenson is an investment advisor representative of and offers investment advisory services through Forrest Financial Partners, LLC, a registered investment adviser offering advisory services in the State of Connecticut and other jurisdictions where registered or exempted. Tel: 860‐222‐0232
Nothing in this article constitutes investment advice and all content is subject to the Legal and Disclaimer Policy of Forrest Financial Partners.
