Midyear Outlook: Out of the Woods?

Executive Summary

While forecasting is more difficult amid today’s uncertain conditions, below is a summary of our market perspectives that may impact opportunities and asset allocation decisions:

• The Fed likely has only one or two more hikes left this cycle, with cuts probably beginning in early 2024. Those with excess cash in bank accounts or money market funds should extend duration in order to benefit from falling rates and to avoid reinvestment risk
• A credit contraction is occurring, impacting the private industries in need of ongoing capital inflows. Lend into the contraction (e.g., to commercial real estate, middle-market companies, etc.) to gain attractive yields and protective covenant terms
• The stock market priced in a recession last October and a new multiyear bull market may have begun. Don’t be underweight equities—ensure your long-term equity allocation is implemented
• The 2H 2023 equity market may be volatile, given a softening consumer. Take necessary 2023 withdrawals now and dollar cost average through the second half of the year (rather than investing all at once)

Global Economic Outlook

United States

So far in 2023, we’ve been impressed—and positively surprised—by the resilience of the US economy. The labor market and consumer demand have each remained strong, forcing economists and the Federal Reserve to raise expectations for both growth and interest rates for the year.

In our January outlook, we highlighted inflation as a key driver, but foresaw it giving way to slowing growth over the course of the year. At this point, the economy continues to chug along in a fairly balanced way—inflation’s importance is diminishing and yet the growth picture has not yet softened enough to become a concern (Display). That trend could continue, but we also recognize several key risks surrounding the pace at which the economy slows.

It's easy to start with “What could go wrong?” That type of analysis seems more tempting these days. But we’re going to resist the urge and begin with the contrary—what could go right? As it happens, that also aligns with the latest base case from our economics research team. Instead of a sharp contraction, they expect a protracted period of below-trend growth lasting through 2024.

In a nutshell, the optimistic case is quite boring. But don’t underestimate its chances based on its simplicity—or the relatively small word count it takes up here. It’s as straightforward as the economy continuing to employ more workers and wages continuing to grow (but at a lower rate, as the Fed takes some of the heat out of the labor market). At the same time, inflation further recedes as last year’s falling house prices flow through the shelter inflation figures on a four- or five-quarter lag. This will allow US workers’ after-inflation aggregate paycheck to gently rise, which in turn sustains slow, but positive, real economic growth (Display).

At some point, that process will go too far, either on its own, due to excessive tightening by the Fed, or due to a random shock. More significant layoffs will occur, and the economy will shrink. But the timing remains up in the air. What could accelerate the contraction so that it occurs inside the next 18 months? That’s the pessimistic case.

Let’s start with the most obvious culprit, the Federal Reserve (which has ended most historical expansions). On one hand, the Fed’s impact has seemed marginal so far, with the economy largely steaming through. On the other hand, we know that monetary policy works with famously “long and variable lags.” While the Fed started hiking belatedly in early 2022, their initial moves only made monetary policy “less loose” as opposed to “tight.”

When did policy cross into restrictive territory? Not until Q3 or Q4 of 2022, in our view (Display). Arguably, it then took even longer before monetary policy became “tight.” So while this rate cycle has stretched over a year, realistically we’ve only seen two to three quarters of tight monetary policy—and we’d argue the effects of 2023’s hikes have yet to be felt.

What’s more, monetary policy may have been fighting an uphill battle against fiscal policy in recent quarters. As the economy normalized post-pandemic, you’d expect fiscal policy to become less stimulative. Instead, it’s become more stimulative in recent quarters, as the deficit has widened (Display).

Why has the deficit widened? Mainly due to a tax anomaly in early 2022 and tax deadline extensions for millions of taxpayers affected by natural disasters. In early 2022, tax receipts set all-time records, blowing away historical levels. When tax season came around this year, receipts fell short of 2022 by around $300 billion, though they still exceeded all prior years. This left consumers relatively flush, a situation we don’t foresee repeating in the months ahead. Further strengthening our conviction in that is the fact that many California taxpayers, along with those in parts of Alabama and Georgia, have until mid-October to file their taxes, suggesting a measurable surge in tax receipts is likely later this year.

Deficit statistics also widened in late 2022 due to an upfront recognition of the cost of the Biden administration’s student loan forgiveness plan. That’s become moot since the Supreme Court invalidated the policy and the accounting will be reversed. Either way, it’s largely illusory as it never impacted GDP. Could restarting payments on federal student loans put the squeeze on consumers? In our view, the effect will be material enough to be visible in GDP figures but insufficient to cause a recession on its own.

Taken together, we expect the stimulative fiscal impulse from recent quarters to give way to a contractionary impulse in upcoming quarters. When that shift occurs—and meets tighter monetary policy—both forces will be pushing in the same direction, though their combined magnitude remains to be seen.

What about consumers’ balance sheets? We estimate that excess savings from the pandemic has dwindled to around $500 billion, with most of it sitting in affluent hands. At around 2% of GDP, that unexpected windfall could still cushion a downturn. In the meantime, credit card delinquencies have been rising, yet they’re doing so from a record-low base. That mitigates much of our concern, though we’ll continue monitoring the trend.

Another development we’re watching closely is consumers’ tendency to trade down—fancier dinners and splurges are giving way to fast casual dinners and smaller purchases. Many retailers are citing declining traffic, while discount and off-price retailers have noted a pickup. Even impulse purchases are faltering (think soda and candy by the register), according to industry executives.

Ultimately, paychecks are the main engine of consumption. There, the key drivers to watch are overall employment (still growing), nominal wage growth (rising slowly), and inflation (falling, which is good). As inflation fades, the effects of monetary and fiscal policy on total employment and wage growth will become more influential.

But consumption is also fueled to a smaller degree by credit—especially during an economic expansion. To determine where we stand in the consumer credit cycle, we created a rough index of the cost of consumer credit relative to GDP, based on the total amount of non-mortgage credit in the economy and prevailing interest rates. The index essentially tracks the extent to which interest payments are dampening consumer demand. Based on our analysis, we’re concerned that consumers’ interest burden has reverted to near historic highs. We suspect we’ve reached a level that has historically corresponded to lower subsequent economic growth in past cycles (Display).

On the flip side, banks are beginning to tighten credit—both for consumers and companies—with overall loan growth peaking late last year. As it continues to drop, the credit impulse will turn negative.

We see this across several other datapoints, too. First, via an outright decline in outstanding commercial and industrial (C&I) loans—a critical source of funding for businesses and future production capacity. Then there’s commercial real estate (CRE), recently the fastest-growing (and largest) segment of bank lending. We are quite confident that growth rate will fall, given the stresses in the banking system and emerging challenges in the CRE sector. Finally, the Fed’s survey of senior loan officers shows a high and rising proportion of banks tightening their C&I loan standards while a smaller and falling proportion see stronger demand (Display).

While there’s some “chicken-or-the-egg” when it comes to the interplay between lending and economic activity, these datapoints paint a cloudy picture for consumer and commercial credit, along with economic growth. With that said, consumer spending and the household paycheck remain key drivers. A strong enough economy and labor market could sustain slow growth for an extended period. Still, the risks are notable.

How can we pull this all together? While every model has its flaws, we use a quantitative recession tool to estimate the probability of a slowdown over various time horizons. According to our model, the chance of recession spiked sharply in late 2022 across an immediate, six-month, and twelve-month forecast horizon (Display). Some of that was fueled by the changes in the yield curve, but other factors include the stock market (which has recently reversed), the manufacturing slowdown, and changes in the labor market and consumer/commercial lending.

Overall, the model’s current estimates point to a 4% chance that we’re already in a recession, a 59% chance one will occur in the next six months, and a 92% chance that one will unfold at some point in the next year. Notably, we expect these results to fluctuate in the near term. That’s not unusual. Those figures plummeted in recent months—primarily due to the recent stock market rally—after peaking in December at 90%, 98%, and 99%, respectively.

Could the yield curve be throwing off a false signal this cycle? Its inversion may not necessarily indicate an impending slowdown, but rather the need for higher interest rates to control inflation in the short term. If we remove it from the model, what happens? In that case, the odds of a recession in the next six or twelve months fall to 18% and 40%, respectively. Still elevated relative to historical standards, but a far cry from 90% (Display).ⁱ

Markets seem to pay the most attention to inflection points—in other words, when the chance of a current recession is high and rising or high and falling.ⁱⁱ With the current-month recession model odds sitting at around 4%, we’re watching closely for any drift towards riskier levels. What’s more, even if a recession arrives, it would likely be mild by historical standards. The deepest recessions tend to involve financial crises. Yet we don’t see large imbalances in the financial system, and the Federal Reserve and other central banks have been reining in the banking sector for over a decade. Other painful contractions have been caused by significant imbalances in the real economy—we don’t currently see those at play either. As a result, even if a recession materialized, we’d expect a relatively mild economic impact.

Overall, we continue to anticipate a slowdown in the US economy. The outstanding question is just how slow and on what timeline. But ultimately, timing recessions is not the most important aspect of investing for long-term investors. Instead, maintaining exposure over time is crucial. The true friends of a long-term investor are time and the magic of compounding.

Around the World

Outside the US, the global economy has generally remained more resilient thus far, too.

In Europe, the economy has outperformed due to better-than-expected winter weather and rapid adaptation to the new energy reality created by Russia’s invasion of Ukraine. The region still faces headwinds—many of which parallel those in the US—and we continue to expect a slowdown there as well. The UK still faces a deteriorating situation. It shares in the post-pandemic economic woes faced by other developed countries, but those are exacerbated by an inflationary impulse and economic shock of its own making due to Brexit. Recently, the Bank of England raised interest rates by more than expected as falling core inflation reversed course and accelerated to new cycle highs. We continue to anticipate a recession there.

In our beginning-of-year outlook, we flagged Japan as a standout from the rest of developed markets, with a better growth and inflation picture allowing for less restrictive monetary policy. That view appears to be proving out and we reaffirm it today. We’re also keeping an eye on potential changes in their monetary policy regime and its knock-on effects around the world.

China’s economy finally emerged from COVID lockdowns this year. Yet even with a brief rebound, growth is falling short of the government’s targets since they can no longer rely on their historical engines as much. We expect a light economic stimulus boost. But with the government still carefully trying to nudge the economy towards more domestic consumption (as opposed to its historical reliance on exports and real estate), there is a limit to how much they can achieve.

In other emerging markets, the dollar and oil did not have the same impact as they did in 2022 (with the former serving as a wrecking ball and the latter as a ballast). While there are certainly emerging and frontier markets where we are cautious due to their sovereign debt situations, the economic picture continues to improve in many others.

Asset Allocation Implications

Extend Duration

With the Fed’s rate hikes seemingly near an end—and many investors sitting on excess cash—our highest conviction call is to shift towards intermediate-duration, investment-grade credit. Depending on your tax circumstances, that either means investment-grade municipal bonds or taxable bonds.

Many investors have latched onto bonds maturing in the next 6 to 12 months or turned to money market funds to take advantage of elevated short-term yields. However, this comes with its own risks—if rates fall from today’s levels, investors will be reinvesting at lower yields when current holdings mature.

Instead, investors can now secure the highest intermediate-term interest rates we’ve seen in over a decade and maintain those rates for years to come. What’s more, the main risk of doing so—a period of rising interest rates—appears to be diminishing. Though there is still a possibility of rates increasing, we think that they’re more likely to decrease in the upcoming quarters and years. That pivot could occur as the economy normalizes and more money shifts into longer-dated bonds or if there are any economic issues that require the Fed to begin cutting rates. Even if rates remain higher or even rise slightly from here, the benefits of compensation for high-quality credit risk and the tax advantages of municipal bonds can offer an edge over short-term Treasuries or money markets.

2022 was challenging for balanced portfolios as investors lost money in stocks while bonds failed to cushion the blow. Now, bonds seem poised to return to their historical role—delivering stable income with lower risk and mitigating potential equity drawdowns in a portfolio. As long as inflation is no longer the driving story in the markets, bonds should resume their diversifying role.

Investment-grade bonds in particular look attractive at this stage in the cycle. Fundamentals remain quite strong across the board, whether in municipal or taxable bonds. Municipalities are generally in their best fiscal position in years. And many of their corporate counterparts took advantage of low interest rates and government support to fill their coffers while locking in low bond rates for years to come. Although they do not provide the juicy incremental returns they’d offer if we were in a market downturn, we consider the compensation for credit risk attractive relative to fundamentals.

Liquidity Is at a Premium—Get Paid for It

Certain asset classes require a steady inflow of financing. When that flow of cash dwindles, the value of liquidity within that market increases, and investors who provide it can receive compelling compensation.

Right now, the flow of funds into private asset classes has been somewhat constricted. Part of that stems from banks stepping back, part from institutional investors having disproportionate exposure to private assets after last year’s sell-off in public markets, and part from inherent challenges in specific corners of the private markets.

We’d encourage investors seeking higher total returns to take advantage of the liquidity squeeze in private markets, provided they’re able to accept some illiquidity in their portfolio. Notably, we see current and emerging opportunities in a few key areas—commercial real estate debt, private credit, distressed debt, and idiosyncratic secondary transactions. In all these areas, providers of private capital have an opportunity to craft customized solutions for other market participants while generating additional value for both sides.

What About Stocks?

After a sharp run-up in US stocks, many investors are wondering what to do. Generally speaking, we’re inclined to maintain those positions at their long-term weights, even in the face of uncertainty in late 2023 and into 2024. Stocks are, after all, the engine of long-term capital appreciation. And with an elevated risk of inflation over the next decade or more, their high degree of built-in inflation protection enhances their role as an asset allocation pillar, in our view.

For some, the melt-up in stocks so far this year has been a little surprising—for others, it’s less surprising than you’d think. First, the macro backdrop has held up better than expected, reducing (or at least postponing) the risk of a harmful recession. Second, much of the market’s returns have been driven by quality growth stocks, which we highlighted in our beginning-of-year outlook. It’s harder to call that “unjustified.” Third, the vast majority of returns have been concentrated in a handful stocks, mostly connected to the market’s latest hype—artificial intelligence (AI).

Notably, the market is now up over 20% from its October lows—the threshold for a “bull market.” That kind of rally has occurred nine times going back to 1960. Historically, the market has achieved an average return of 19% in the subsequent year, and in none of those past instances has it experienced a decline one year later. While we sometimes write off that type of datapoint as the investing equivalent of color commentary, it’s still nothing to sneeze at.

Of course, there are some mitigating circumstances to consider. Past bull markets have usually kicked off early in an economic cycle, whereas we seem to be firmly late cycle. Plus, those past bull markets were usually fueled by a broad swath of stocks, including many smaller companies. In contrast, this year’s narrow rally was propelled by a handful of the largest companies and a single big theme, with the rest of the market now playing catchup.

Artificial Intelligence—the Real Deal?

That raises the question of how to think about AI and its bearing on the economy and markets. Let’s start with the most direct impact—the companies that provide high-end chips for AI model training and those monetizing AI models at scale will benefit most in terms of revenue and profits. Unsurprisingly, these are the stocks that immediately came into focus and surged.

Who else stands to benefit? Broadly speaking, everyone to some degree. AI promises to deliver a step-change in productivity, but it will take years to implement and reap the rewards. The primary advantage is that we can produce more goods with the same resources, leading to higher productivity and real GDP growth. As a result, we will be able to spend more money on various things, and the global revenue base will increase, along with profits.

At the same time, we put less credence in the idea that AI will be a gamechanger across the board. Most companies face enough competition that this advancement will just raise the table stakes. Take your typical manufacturing or retail business. Their peers will use AI, and so will they if they want to remain competitive. Ultimately, they’ll spend to avoid losing, not so they actually gain. Companies may try for a more positive spin, but as with adopting any new technology—from cars to phones to the internet—it will just devolve into another arms race. Some new business models may emerge, and others may be permanently impaired. Thankfully, like other technological revolutions, it’s likely to benefit everyone through faster economic progress (unless, of course, robots take over, as some fear).

Other Opportunities

Beyond AI, we see healthcare as a theme/sector creating opportunities. Medical procedure volumes are still normalizing post-pandemic, leaving meaningful upside for revenues and profits. In addition, in a slowdown or a worse downturn, those volumes should continue to normalize, making those earnings more resilient through the economic cycle. Even so, current valuations are not overly demanding.

We remain slightly overweight the US in our long-term allocations but do see some opportunities internationally. Japan, which we highlighted in our year-ahead outlook, has been the best performing market so far this year. And with fundamentals still strong, we continue to view it favorably. Companies in certain sectors in Korea and Latin America also appear attractive. China still commands our interest and valuations look attractive, but the growth side of the equation remains unclear, both for the economy overall and analyst estimates of companies’ earnings.

A Linear or Non-Linear Future?

Investors often find this phase of an economic cycle challenging. Economies and markets are complex systems. They can quickly shift from an orderly state to a disorderly one.

Since it’s summer, the simplest analogy is a pile of sand on the beach. As you add more sand to the pile, it can continue to grow quite large. But at some point, the next grain of sand may cause a slide. Until that point, it’s hard to judge how many more scoops you can add and how high it can go, let alone the magnitude of the slide. While human behavior is obviously more complicated, recessions work in much the same way—at some point, a seemingly small change can trigger a much bigger effect downstream.

The past several economic expansions have persisted even as calls for an impending recession have reached a crescendo. Throughout history, investors have likely lost more money by trying to avoid recessions that failed to show up “on time” than they have by holding steady through various downturns.

The markets may be out of the woods for now. But downside economic risks remain salient. As we venture further forward, we can also spot new opportunities coming into view. In general, we believe investors should stick close to the path. There aren’t many areas which currently pique our interest, but the ones that do—intermediate-duration investment-grade bonds and providing liquidity in private markets—appear quite attractive. That’s where we’d suggest putting incremental funds. For the most part, though, we’re holding steady and focusing on the long term. That’s where the real dollars are made through time.