MIXED GLOBAL OUTLOOK
Global economic activity remained resilient through the third quarter of 2023 despite considerable monetary tightening by global central banks over the past 18 months, which prompted speculation earlier this year that a U.S. recession was imminent. Recession calls have quieted recently as hard economic data in the U.S. have come in stronger than expected, even as soft survey data remained weak. Strong labour demand has provided a buffer to household incomes and supported private consumption, while fiscal stimulus continues to boost the economy. The most likely economic scenario is one of modest U.S. growth in the back half of 2023 and into 2024, with a lower risk of recession in the near term.
Even in the absence of a recession, elevated interest rates will have a negative impact well into 2024. Business and residential investment are often at the recession vanguard due to their sensitivity to interest rates. High mortgage rates have pushed U.S. residential investment significantly lower in 2022 and so far in 2023. This weakness comes as historically low home inventories – driven in part by continued population growth amid supply shortages – have driven home prices to elevated levels, contributing to the recent bout of inflation.
While the U.S. outlook has some risks on the horizon, the international outlook is cloudier. Europe’s post-COVID recovery has already faded, with Q2 GDP growth just barely positive in the Eurozone, U.K., and Switzerland. The risks of a European recession are significant as consumers and businesses continue to struggle under the weight of higher interest rates and elevated energy costs. Weak growth is likely to continue in China, barring significant measures by the government to jumpstart the economy. While the People’s Bank of China has cut interest rates, it has held back from a “bazooka” stimulus to restart Chinese real estate sector.
Central banks are making progress in their fight against inflation. U.S. headline inflation remains driven by geopolitics and OPEC+ supply cuts, but core inflation has declined from its peak. Eurozone core has moderated slightly from its recent high. Although their hiking cycles appear to be ending, the U.S. Federal Reserve (Fed) and European Central Bank are likely to keep monetary policy tight until they have more confidence that they can reach their inflation goals.
MAGNIFICENT MODERATION IN EQUITY MARKETS
Global equity markets delivered mixed performance for much of the third quarter, with U.S. stocks pulling back modestly despite better-than-expected corporate quarterly results. The dominance of a narrow field of mega-cap stocks moderated this quarter following exceptional performance in the first half of the year. Risk assets experienced cross currents from uncertainty regarding economic growth, central bank policy, and commercial real estate fragility, which were offset by optimism surrounding artificial intelligence and a resumption in interest rate increases across the yield curve. Uncertainty trumped enthusiasm and balanced risks flattened returns.
We have shifted our outlook to be more balanced as the recent economic data in the U.S. lessens the probability of a near-term recession occurring. The third quarter also likely marked the trough in the earnings cycle, as growth expectations for future quarters turn positive and move past the negativity of Q2. However, we are cognisant that the high valuations of U.S. equities already price in an optimistic scenario, so it’s difficult to see much further upside.
BALANCED OUTLOOK WITH CAUTIOUS OPTIMISM
The improved economic picture in the U.S. has prompted us to shift our outlook to a more balanced position. We are broadly neutral on equities as much of the positivity seems to have already been priced in, while possible negative scenarios remain on the horizon. Within equities, we prefer U.S. and Japan over Europe, as Europe will likely experience more challenges in its fight with stagflation. We think credit has a more attractive risk-reward tradeoff. With the Fed near the end of its rate hike cycle, our view is that opposing forces will keep interest rates relatively stable in the U.S., so the higher rates of lower duration assets appear more attractive. Although energy is recovering, it is supply-side driven and other industrials look poised to stay depressed given China’s economic weakness. We remain concerned about the commercial real estate sector and the resultant overhang on the banking sector. Although Q3 has been calm, we don’t think we’re out of the woods yet.
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