Stephen M. Mills, CIMA® Partner
Chief Investment Strategist
Brad Bays, CIMA®
PIM Portfolio Manager
- The stock market rebounded from prior year losses in the first 3 quarters of 2023.
- The U.S. economy continues to show moderate but slowing growth led by consumer spending and a strong labor market.
- The rate of inflation in the U.S. continues to recede.
- The U.S. Federal Reserve has raised the fed funds rate three times in 2023.
We believe there are three primary factors currently influencing the financial markets and will likely drive both stock and bond prices over the next 6-12 months: 1) the direction of the economy, 2) inflation expectations, and 3) the Federal Reserve’s monetary policy. There are certainly specific issues, like the UAW strike, rising oil prices, the war in Ukraine, next year’s presidential election, and the employment picture that will influence what happens with the markets in the near term but we feel the three factors mentioned above will be the key variables to watch moving forward. We will address each one of these factors in the following commentary.
First, let’s address the current state of the U.S. economy and our forecast for economic growth over the next year. Currently, U.S. economic growth, while slowing, remains solid according to recent positive data. Through the first half of the year, inflation adjusted U.S. GDP (Gross Domestic Product), often referred to as “real” GDP, grew by an inflation adjusted rate of 2%.1 In our view, that is remarkable considering the degree in which the U.S. Federal Reserve (Fed) has increased interest rates significantly since beginning their rate-hike cycle in March, 2022. The Fed has taken the fed funds rate from nearly 0% to 5.5% through a series of rate-hikes over the past 18 months. Such an increase in rates would typically slow the economy and possibly even cause a recession. That has not happened, yet. Real inflation adjusted GDP is expected to grow by an annual rate of 1.9% in the third quarter, according to the Federal Reserve Bank of Philadelphia’s survey of professional forecasters.2 The forecasters expect real GDP to grow at an annual rate of 2.1% in 2023 and 1.3% in 2024.2
Coming into 2023, most economic forecasters were calling for a mild-to-moderate recession beginning sometime in 2023, however, perhaps the most anticipated recession in history for the U.S. economy has yet to materialize. Although we still have a quarter remaining in the year, recent economic data suggests continued growth for the rest of the year.
The U.S. consumer remains primarily responsible for the growth in the economy this year, in our view. Consumers continue to spend money on travel, entertainment, and dining. Recent data also shows good demand for durable goods like homes, automobiles and household items as well. This is all in spite of higher interest rates. Although mortgage loan rates moved above 7% this year, both housing demand and prices have remained resilient. In addition, retail sales rose by .6% in August for the fifth consecutive month of increases.3 Some of this increase was due to rising gasoline costs, however overall, consumer demand remains moderately strong.
One of the main drivers of consumer spending is consumer finances. The chart below breaks down the U.S. consumers overall balance sheet. Consumer assets remain at a historically high level at $168.5 billion while consumer liabilities are low by comparison at $19.6 billion, most of which is made up of mortgage loans. Debt payments as a percentage of consumer disposable income is currently 9.7%. Although the percentage has increased from 8.2% at the end of 2021, it is still much lower than the 13.2% level reached in 2009. We believe this is one of the reasons consumer spending remains resilient in spite of higher interest rates. Something to watch moving forward is the impact of the resumption of student loan debt payments. Student loan debt, which is currently at $1.76 trillion, represents 9% of the total debt. The Biden administration froze student loan debt payments in 2020 during the pandemic. On June 30, 2023, the Supreme Court blocked President Biden’s student debt cancelation plan. As a result, interest began to accrue on all student loan debt September 1st and payments will resume in October of this year.4 It remains to be seen how this will impact overall consumer spending.
On the industrial side of the economy, manufacturing output has continued to grow modestly in 2023. Industrial production increased by .4% in August and has increased by 1.9% year-to-date as of August 31.5 In addition, the labor market continues to be strong although we are starting to finally see some weakening in the monthly job gains per the U.S. Bureau of Labor Statistics August jobs report. Although the economy added 187,000 jobs for the month of August, the unemployment rate jumped to 3.8% from the previous months rate of 3.5%.6 The report indicates that labor supply is increasing as more workers enter the workforce for the first time since the pandemic. It appears that the labor supply/demand picture may be coming back into balance after several years of supply shortages.
Overall, we believe that the U.S. economy has largely shrugged off the effects of rising interest rates so far this year. While the economy remains on solid footing so far, we are starting to see some cracks in the growth narrative and indications that there is at least a potential for an economic slowdown and possibly a mild recession in the next in the next 12-18 months. We believe the lag effect of higher interest rates will begin to take a toll on both business and consumer spending. We are already seeing signs of a spending slowdown in the business sector as business confidence in the economy continues to wain due to concerns about the impact of inflation and increased borrowing costs. Higher inflation and borrowing costs cut into profits and curtail business spending which is starting to show up in the monthly data.
Since the middle of 2022, there has been significant progress made on the inflation front. The chart below shows historical data for “headline CPI” (Consumer Price Index) as reported each month by the Bureau of Labor Statistics (BLS) as well as “core CPI” which excludes food and energy costs. Headline CPI peaked in June of 2022 at an annualized rate of 9.1% while core CPI peaked at 6.3%. Since then, there has been a sharp reduction in the headline CPI to 3.7% on a year-over-year basis, as of the August BLS inflation report.7 The BLS also reported that Core CPI has fallen from its June 2022 peak but still remains at a historical high level of 4.3% on a year-over-year basis. We anticipate more downward movement for inflation over the next 12 months although the pace of the decline will likely slow somewhat. We see core CPI staying in the 3-4% range for the foreseeable future while headline CPI remains somewhat volatile due to energy prices.
Federal Reserve Monetary Policy
If both the U.S. economy slows in the second half of the year as we expect and inflation continues to fall, the Fed may be able to end the rate-hike program they began in March of 2022. The Fed did not raise the Fed funds rate at their June Federal Open Markets Committee (FOMC) meeting but came back in July and raised the rate by .25% to 5.5%, a 22-year high.8 The Fed paused their rate hike strategy again at the September FOMC meeting. Most economists expect the Fed to raise rates one more time before the end of the year in either their November or December meeting, before pausing for a more extended time period to assess the economic impact of the higher rates.
The Fed tends to pay more attention to core CPI as well as core PCE (Personal Consumption Expenditure Price Index), which is calculated differently than the CPI. On a 12-month basis, according to the August U.S. Commerce Department report, core PCE rose 3.9% which was down from its peak of 5.2% in September 2022.9 Both the core CPI and the PCE inflation measures have improved significantly since peaking in 2022.
Chairman Jerome Powell and other Federal Reserve board members have continued to emphasize their determination to get inflation back down to its 2% target rate and have made significant progress toward reaching that goal. We expect the Fed to remain diligent in their effort to bring inflation back down to their target. If the economy slows as we expect and perhaps falls into a mild recession, then the Fed may start lowering rates sometime next year. However, our mindset remains that the Fed will keep rates higher for longer.
September was a rough month for the equity markets as the S&P 500 Index fell 4.8% while the Nasdaq-100 Index lost 5%.10 However, year-to-date through September 30, both indices recorded gains of 13% and 27%, respectively (including dividends).10 The majority of the gains in both of these indices can be attributed to a few large company growth stocks. In fact, just seven mega-cap stocks are driving the majority of the equity returns this year. As of September 27, these seven stocks have risen on average 80.1% and have accounted for the majority of the gains of the market-cap-weighted S&P 500 Index.11 The S&P Equal Weighted Index, which assigns the same percentage weighting to each of the 500 stocks, is essentially flat, down .1% for the same time period.11 While the stock market has been very narrow so far this year, we expect the market to broaden out as we move forward.
We continue to be encouraged by the resilience of the U.S. economy. We feel this resilience will translate into better corporate earnings as we move into next year. We believe the biggest determining factor of the performance of stocks is investor expectations of future corporate earnings growth. As we sited above, we see the direction of the economy, inflation, and interest rates having the most impact on financial markets over the next 6-12 months. Corporate earnings are certainly impacted by each of these factors. However, we believe that company managements will be able to navigate through these challenges and continue to grow earnings.
We see earnings growth for the S&P 500 Index re-accelerating in 2024 as year-over-year earnings comparisons become very favorable after several quarters of contracting earnings in 2022. The adjacent chart shows S&P 500 annual earnings going back to 1988. The green bars represent what is referred to as an “earnings recession,” which is when the year following an earnings cycle peak fails to exceed the previous peak year. You will notice that 2022 was an earnings recession year as the S&P 500 earnings declined from 2021. The chart shows that 2023, 2024 and 2025 will be positive growth years for S&P 500 earnings, according the consensus analyst estimates. If these estimates are realized, we believe they will provide a positive catalyst for stock prices in the fourth quarter of this year and in 2024.
We believe the risks to stocks include a possible economic recession in 2024 and continued rising interest rates. While we don’t feel that a mild recession would have a major negative impact on stock prices, if the economy experiences a more significant downturn, stocks would likely fall and possibly even give back most if not all of their gains this year. In addition, if interest rates continue to rise, we believe stocks would have a difficult time making much progress. Negative geopolitical events, continued rising energy prices and election year politics could also have a depressing effect on stock prices.
Despite these risks, we remain constructive on the stock market for 2024. We would use any further near-term weakness in stock prices to put cash to work in selective areas of the market. As we have recommended for the past two years, we continue to favor high-quality, dividend-paying U.S. mid and large company stocks. These stocks have on average underperformed the growth stock sector of the market so far in 2023 as investors have allocated cash to the growth areas of the economy like technology and consumer discretionary. However, we believe as the economy weakens, investors will migrate more toward stocks with consistent earnings and dividend growth. (Dividends are not guaranteed and are subject to change or elimination)
High dividend sectors like utilities, REITs, and certain consumer staples and healthcare stocks have been under pressure this year with rising interest rates. We see value in these sectors but caution that investing in these stocks may demand patience if interest rates continue to rise. We would continue to avoid adding cash to small cap and international stocks at this time, but would hold existing allocations in these asset classes.
We also continue to be positive on the energy sector. We believe energy stocks present an excellent long-term buying opportunity as the supply-demand picture remains favorable for both oil and natural gas, in our view. With oil prices now in the $80-90 range,10 we believe the cash flows for energy producers should be very strong for the foreseeable future. We believe these rising cash flows will allow producers to increase capital spending on oil and gas production activities as well as potentially raise dividend payouts to investors.
The bond market continues to struggle this year after recording one of the worst years on record in 2022. Prices of high-quality securities like Treasury instruments, high-grade corporate bonds and municipal bonds, which in the first half of the year posted modest gains, have recently fallen into negative territory for the year. Rising yields are the culprit. The 10-year U.S. Treasury Note, which began the year with an interest yield of 3.9%, ended the third quarter yielding 4.6%.10 Yields for other fixed instruments have risen as well over the past several weeks.
Bond yields have broken out to the upside recently for both short-term and longer-term U.S. Treasury securities, according to our technical indicators. We use these as benchmark securities to assess the overall condition of the bond market. These rising yields have caused interest sensitive investments like bond funds, utilities and REITs, precious metals, and small cap stocks to hit fresh lows for the year.
We believe yields are rising because investors appear to be anticipating a period of stagflation reminiscent of the 70’s when inflation remained above 5% for most of the decade and economic growth was below average. We don’t expect inflation rates to stay as persistently high this time around nor interest rates to reach the same levels as they did in the late 1970s and early 1980s. Looking back, most economists believe the Fed did a very poor job of combating inflation during those years. Today’s Fed seems determined to bring inflation rates down by aggressively raising interest rates and keeping monetary policy tight until they reach their 2% target rate.
Continued issuance of Treasury securities to fund U.S. Federal government deficit spending is also putting upward pressure on interest rates, in our view. Based on the technical charts we follow, we believe the 10-yr Treasury Note could reach a 5% yield soon. However, if recession fears begin to creep into the markets, yields could move back down until there was further clarity on the economy. On a positive note, most high-quality money market funds are now yielding over 5% and we do not expect this changing in the near future.
The Bottom Line
There are many uncertainties facing investors in the near term. The UAW strikes, the risk of a government shutdown, the war in Ukraine, rising interest rates, inflation, and the potential of a recession are all issues that will impact financial markets for the foreseeable future. These risks can make it very difficult to invest and can lead to investment paralysis. While we believe these conditions could create more volatility in financial markets in the near-term, they can also create opportunity to put cash to work in high-quality investments, where appropriate.
Equities is one area we would consider adding cash to between now and the end of the year for investors seeking additional equity exposure. With the improvement in the overall stock market this year, we believe we are no longer in a bear market. In our view, the bear market ended in mid-October, 2022, when the S&P 500 hit 3500, down 27% from its January 3rd 2022 high. From that bear market low, the S&P 500, even with the 8% correction we have experienced recently, is up nearly 20%. However, we are not yet ready to declare a new bull market. That may come when the S&P 500 takes out its January 2022 highs. We believe those highs may be topped sometime in the next 12-18 months, based on improving corporate earnings and a stabilization of the Fed’s interest rate policy.
In the meantime, we will continue to evaluate market conditions and keep you informed of the latest economic and market developments. As always, we greatly appreciate your continued trust and confidence in us.
Your Trinity Capital Management Team
Tyler TX Location
821 ESE Loop 323, Suite 100
Tyler, Texas 75701
10 Thompson charts
11 Wells Fargo Investment Institute, Chart of the Week, October 3, 2023
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