“The U. S. government will always do the right thing after it’s exhausted every other option.” — Winston Churchill
Second Quarter Summary
Most equity markets continued their rally during spring, with fixed income pulling back after a good first quarter. Precious metals (such as gold) dipped moderately while commodities fell, led by the more cyclical copper and oil. The dollar ended flat.
So far this year, the biggest theme has been the resilience of the U. S. economy despite the rapid increase in interest rates beginning in March 2022. Real Gross Domestic Product (GDP) grew at an annual rate of 2.0% the first quarter, up from earlier estimates of 1.0%.
The second quarter has followed in similar fashion with forecasts close to 2.1%. The job market remained tight with unemployment at 3.6%, up only marginally since its multidecade lows of 3.4%. All this good news is being tempered by the glacial progress to harness inflation. The core rate (excluding energy and food) lingers between 4.5-5.0% and still a long way from the Federal Reserve’s goal of 2.0%.
Concerns Not Realized
In early spring, there were concerns that the failures of SVB Financial and Signature Bank would force regional banks to tighten credit standards. To date, tightening has been rather modest although it is still early.
There was also angst in April and May about a possible failure by Congress and the President to raise the debt ceiling. Fortunately, an agreement was reached before the critical early June deadline. However, many see the two-year deal as kicking the can down the road.
The strength in the economy, concerns that haven’t yet surfaced and rhetoric from the Fed have dashed any hopes for an imminent pivot in the Fed Funds rate. The markets have finally realized that higher interest rates will continue into the near future. This is also occurring globally with central banks in the UK, Eurozone, Canada and Australia reflecting similar narratives.
Liquidity and Other Factors Influencing Stocks and Other Asset Classes
Since the low of last autumn, equities have been helped by the Fed providing extra liquidity to the financial system, even though rates have been rising and the Quantitative Easing (QE) program is being unwound. Chairman Powell has been keen to keep something in the economy from “breaking.” A recent example of this has been the Bank Term Funding Program (BTFP) instituted shortly after the SVB and Signature Bank failures to assist regional banks in meeting deposit drawdowns by customers. This has, however, diluted the overall tightening of monetary policy.
Moreover, due to the prolonged period of extremely low rates following the Great Financial Crisis in 2008, both consumers and corporate borrowers had time to lock in low borrowing rates for extended terms. This has made the sharp rate hikes in Fed Funds less effective than usual.
Housing has also been abnormally affected by higher mortgage rates. While initially limiting the number of home borrowers, the high rates are also freezing existing homeowners with low-rate mortgages in their homes, thereby limiting supply. This has contributed to putting a bottom for home prices
Finally, effects of the pandemic have caused various parts of the economy to grow and contract at separate times. The most obvious has been the goods sector which first boomed then contracted. Conversely, the service sector shrank then picked up as Covid vaccines became available. This has led market strategists to describe the varying performance of distinct parts of the economy as “rolling recessions.” These factors have all extended overall growth and contributed to the equity rally in the first half.
Investment Implications and Outlook for the Second Half
With the economy and corporate earnings coming in better than expected so far in 2023, we have:
- Selectively added back to some growth stocks that have corrected in price but possess characteristics resistant to an economic slowdown including such areas as AI (Artificial Intelligence), cyber security and EVs (Electric Vehicles)
- Maintained our overall asset allocations, as we believe that current interest rates make fixed income an attractive alternative to equities for the first time since the GFC
As stated in quarterly commentaries since last fall, we still anticipate a significant slowdown in the economy by year-end and perhaps even a recession, due to the lagged effects of interest rate increases and an inverted yield curve. However, any recession will probably be mild, with both consumer and corporate balance sheets in much better condition than in previous downturns and the mitigating effects of rolling sector recessions. The reduction of the labor force due to Covid will also prevent unemployment from increasing as much as in previous economic cycles.