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Second Quarter 2023 Market Commentary

The second quarter was another strong one for stocks, with the S&P 500 gaining 16.9% in the first half of the year. Apart from the banking failures, this has been a goldilocks year for markets and investors. The economy has remained surprisingly resilient despite rising interest rates while inflation has cooled significantly. 

At the beginning of the year, the main question on everyone’s mind was whether the Fed would be able to bring down inflation without triggering a recession. The hope was that the Fed could steer us towards a soft landing, where we have only a mild contraction in the economy as opposed to a hard landing. However, as the economy continues to grow and the labor market remains strong, some analysts are now wondering if no landing is possible: meaning we won’t even have an economic contraction as a result of the Fed’s tightening. 

My base case is still that the US enters a recession sometime in the next year. In this commentary, I will explore the arguments for and against this scenario and also emphasize the importance of investing with caution in light of high valuations and risks for financial assets. 

No Landing or Soft Landing

In my Q1 2022 commentary, I noted signs of a potential future recession when the yield curve inverted. The yield curve, which measures the difference between long-term and short-term interest rates, has been a reliable predictor of every US recession since 1955. On average, it takes about 15 months from the time the yield curve inverts to the time the recession begins. By that logic, we should be in a recession right now!

However, as you may have noticed, we are not in a recession yet. In fact, the economy has been surprisingly resilient in the face of multiple headwinds such as rising interest rates and inflation. Q1 GDP was just revised upward to a real annualized growth rate of 2%. Coincident indicators continue to show economic growth in the US. The Atlanta Fed’s GDPNow forecast is predicting Q2 GDP growth of 2%: 

Bill Mcbride, the author of the blog Calculated Risk, is one of my favorite voices on US economics. He was one of the few who foresaw the Great Recession and warned about the housing bubble. He has also been consistently right in dismissing the pessimists and the recession callers since the recovery began. He’s still somewhat optimistic about a soft landing scenario: “Further rate increases would likely be a policy error and increase the odds of a recession…. My sense is growth will stay sluggish in 2023, but the economy will avoid recession. Monetary policy is restrictive, the fiscal policy will be a slight drag if the recent agreement passes the House and Senate. Vehicle sales will probably increase this year, but new home sales will stay low – but increase year-over-year for the remainder of 2023.” 

Mcbride mentioned heavy truck vehicle sales, which usually decline sharply before a recession. As the chart below shows, trucks sales are still strong and not even hinting at a recession at the moment: 

Another indicator that often falls before a recession is new home sales. The next chart shows that after a decline due to higher interest rates in the past two years, new home sales have bounced back and are now positive:

Fed Chair Jerome Powell is also hopeful that we can avoid a recession. “I continue to think that it’s possible that this time really is different. Avoiding a recession is, in my view, more likely than having a recession.” However, I wouldn’t put too much weight on the Fed Chair’s forecast. Ben Bernanke infamously told Congress in 2007 that subprime was contained and the impact on the broader housing market and the economy would be limited shortly before the great recession began.  

The economy has shown itself to be remarkably resilient in the face of aggressive rate hikes. While most industrial sectors have suffered a slowdown, the services sector has kept the economy growing. Now it seems that the industrial sector may be stabilizing while the consumer keeps spending and services stay solid. That opens the door to the possibility the economy muddles through the rest of the year without much contraction. 

Hard Landing

There is a mountain of data and economic indicators that all point to an impending US recession. I was almost overwhelmed by the various charts and data points warning of a recession. Rather than try to break them down individually or pick and choose I decided to put together a graphic of some of my favorites: 

The charts show the following:

  • Cardboard box shipments are deeply negative
  • Employment for Temporary Help Services has turned negative
  • Demand for Commercial Real Estate Loans is at its lowest in 20 years
  • The majority of banks are tightening lending standards
  • Conference Board’s leading economic indicators have been negative for nearly a year
  • Retail same-store sales are negative
  • Capex has contracted significantly
  • US Gross Domestic Income (GDI) is contracting (only seen in recessions)

A few additional points not shown in the charts: 

  • Mortgage rates over 7%
  • Commercial Real Estate has a massive wave of upcoming refinancing that will occur at substantially higher rates than legacy loans. 
  • PMI/ISM in contraction
  • Bank Deposit Outflows
  • S&P 500 earnings declining
  • Extreme stock market valuation
  • Inverted Yield Curve

One final worry is the student loan payment restart. The fiscal stimulus during Covid had a big impact on the economy because a lot of the money went to the young and poor. They are the ones whole are most likely to spend and therefore they can have an outsized impact on the economy. Restarting loan payments hits that exact demographic and may have a big impact on spending in the other direction. What happens when you suddenly impose a $200-300/month payment on someone living paycheck to paycheck? 

Conclusion: Recession or Not? How to Position Oneself

I always like to try and talk about markets in a probabilistic way. More things could happen in the future than will happen. Forecasting markets and the economy is a notoriously difficult task. The data overwhelmingly point to an impending recession. However, the consumer has held up much better than historical data would’ve indicated given the aggressive rate hikes. That being said, I still think that we will enter a recession sometime in the next year. 

The specter of recession is not what keeps me up at night. My biggest fear is the extreme valuation levels of the US stock market. Sky-high equity valuations combined with an economy teetering on the edge of a recession is a horrific setup for investors. When the US economy entered a recession with valuation levels even approaching those of today, the result has been a decline of 50% or more every single time. 

Positioning your investment portfolio without regard to valuation and expecting no recession is a recipe for disaster. On the other hand, a defensive investor can still earn a reasonable return with today’s interest rates even if a downturn doesn’t happen yet.

Scott Caufield, CFA, CPA