In This Article
A TENUOUS GLOBAL GROWTH OUTLOOK
The global growth outlook for the balance of 2023 appears tenuous. In the U.S., the strong labor market helped the economy weather the regional banking and debt ceiling dramas, and recent economic strength supports the view that the U.S. could avoid recession. Meanwhile, Europe must contend with rising interest costs, which are already weighing on Eurozone consumers, while weaker demand from China is a negative for manufacturing.
On the inflation front, expectations are for a significant decline from last year’s levels. Weakening energy prices and more favorable base effects have already driven headline inflation in developed economies notably lower, although core inflation remains elevated.
At its June meeting, the U.S. Federal Reserve (Fed) announced a “hawkish” pause and signaled that it was likely not done hiking rates. Strong underlying price pressures suggest that core inflation will remain elevated, supporting the odds that policy rates will remain high. Japan’s relatively slower pace of inflation growth has allowed the Bank of Japan (BoJ) to hold rates low, though new BoJ Governor Ueda announced a monetary policy review that sets the stage for a change in policy. With China’s economy struggling to regain its footing in the face of reopening, the People’s Bank of China surprised with a cut in lending rates in mid-June. Additional targeted policy support in the second half of the year is likely.
THE HOUR IS NOT YET DARKEST, SO WHY THE DAWN?
Risk assets posted strong gains in the first half of the year. Global equity markets led by the U.S. posted strong gains in the second quarter as companies exceeded quarterly earnings expectations and communicated stronger outlooks. Driven by significant optimism around the prospects for AI, the performance of the S&P 500 year to date has been top-heavy, with mega-cap tech firms accounting for nearly all of the index's gains. The strong gains in risk assets elicited increasingly divergent views from market analysts. Some pointed to the economic resiliency of “hard data” and the probable end to the Fed’s hiking cycle, along with generative AI’s impact on productivity and profits of tech firms, as reasons for earnings to rebound. The contrasting view noted the lagged effects of tighter monetary policy working its way through the economy as well as the impact of negative economic “soft data,” such as the ISM Manufacturing Index and service sector surveys. From our perspective, comments from the Fed and implied expectations of the Treasury market suggest we are nearing the tail-end of interest rate increases. Along with tightening lending standards and narrowing employment slack, we see a set of classical end-cycle measures that are likely to impart economic consequences:
- The lagged effects of the drastic interest rate hiking cycle are likely to have material impacts on the real economy, and in turn corporate earnings.
- The rising cost of capital will impact spending and investment, which we believe is already being felt by the canaries in the coal mine – America’s small and mid-sized businesses.
- Despite the halo effect of AI on the technology sector, many tech firms are heavily dependent on consumer spending and advertising, cyclical areas of the economy that would be sensitive to a slowdown in corporate spending or the labor market.
However, the sustained strength in the economy – as outlined in the economic outlook – has made it difficult to make sense of the market environment. The Fed views the economy and inflation as robust enough to withstand further rate hikes later this year. And despite easing labour shortages, job gains in the U.S. remain exceptional. Although earnings growth was less than stellar, the negative trend has stabilized, and earnings guidance has been positive. Earnings growth expectations for 2023 are close to flat but positive expectations for 2024 have been received well by risk markets. Forward PE multiples for U.S. equities are currently at the most expensive decile over a 20-year history. Comparing the equity earnings yield to fixed income real yields, investors are demanding the smallest premium to hold risky equities since 2007.
With comparable earnings growth and profitability but more attractive valuations than in the U.S., we find Japan and pockets of Europe relatively more attractive. While China’s reopening tailwinds have not materialized, and returns have disappointed, renewed support by policymakers in China is a positive. A Fed pause might support emerging market equities, but slower global growth is a negative, especially for exporters.
The intense investor focus on commercial real estate has subsided a bit, but the sector’s problems still remain. Prices from market transactions will likely result in more accurate marks in private asset investor books, which could precipitate further selling and forced deleveraging.
Commodities have had a difficult first half of 2023. Slower cyclical growth will continue to weigh on industrial metals and energy. Furthermore, China’s lackluster reopening has not provided the tailwinds for commodities that we expected.
A CONFLICTING OUTLOOK WARRANTS CAUTIOUS OPTIMISM
We see the current mosaic of macro and market data as historically consistent with recessions and lackluster risk asset returns. Despite the positive performance of risk assets in the first half of 2023, we err on the side of caution, preferring to wait for evidence that supports the continuation of the risk-on rally. A still-hawkish Fed, stricter bank lending, negative business surveys, and high valuations are all reasons to favour quality and safety. We remain skeptical that markets have somehow skipped the end of the business cycle; markets rarely bottom before a recession. At the same time, sustained economic strength at the end of the cycle could keep investor optimism higher for longer. The conflicting outlook between fundamentals and sentiment prevents us from decisively planting a flag in either a bullish or bearish camp at the moment. Therefore, we believe it is appropriate to take only measured active positions in the major asset classes.
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