News and Commentary

2023 Market Outlook – July

The U.S. economy continued to defy the odds of a recession through the first half of 2023. After some political theatre, the government avoided a major self-inflicted error by raising the debt ceiling, allowing attention to turn to the economy. On balance, we would argue, the economy has improved relative to where it was at the start of the year. Inflation continued to make progress towards the Fed’s 2 percent target, while the U.S. labor market remained incredibly resilient. However, it is important to remember that it takes time for the Fed’s more restrictive monetary policy to impact the economy. A proper assessment of where we are headed requires a deeper dive into some of the factors that drive the economy.

Labor Market

Despite concerns about a recession and weakness in some segments, the labor market has remained strong. The concern last year was that the labor market was in fact too strong, as a tight labor market forces employers to compete for labor by raising wages to attract and retain workers, and the higher wages can amplify the inflationary pressures the Fed is working to contain. Further, one could argue that the modest weakness we have seen is exactly what the Fed is looking for, weak enough to see wages pressure come down, but strong enough to absorb some of the layoffs that we’ve seen. It would be surprising if we didn’t see some further weakness in the labor market in the balance of this year, but a strong labor market continues to be a major reason the economy surpasses expectations.

Technology

Arguably, the recent advancements in technology and artificial intelligence (AI) are some of the most positive factors driving the U.S.’s economic growth. Although in their early stages, these innovations are already being compared to the invention of electricity and the Internet in terms of their ability to increase productivity and positively impact the forward-looking nature of the markets. Long-term, the economic growth of a country will be driven by population growth and how productive the population is. Technological advancements, such as ChatGPT, can help to increase productivity throughout our economy, create new jobs and automate others. According to global consulting firm McKinsey, AI could add to the global economy the equivalent of $2.6 trillion to $4.4 trillion annually, roughly the size of the United Kingdom’s economy1. Technological advancement is something we’ve discussed in prior outlooks, but recent advancements are signs the theme is materializing and have the potential to significantly improve economic growth in the years to come.

Geopolitical Tensions

Geopolitical tensions continue to escalate across the globe. In March of this year, China and Brazil struck a deal to trade in their own currencies, bypassing the U.S. dollar. In June, the United States struck major deals on technology and defense with India, which recently surpassed China as the world’s most populous country. Recent internal fighting within Russia illustrates the challenges it is having with its war with Ukraine. From a global perspective, we are in the beginning stages of a major geopolitical shift, where global powers, namely the U.S. and China, battle each other for global economic supremacy. Other countries will be forced to pick a side or try and amicably work with both. These shifts are likely to result in continued uncertainty for the foreseeable future, but the United States is in the enviable position of the world’s largest economy and the world’s reserve currency. No other country innovates like the U.S. or has the legal system to protect private property rights and encourage investment.

Onshoring and Renewable Energy

With the 2022 enactments of the Inflation Reduction Act (IRA) and the Creating Helpful Incentives to Produce Semiconductors (CHIPS) Act, the U.S. is making great strides to invigorate domestic manufacturing and energy production, which are proving critical in a global environment fraught with geopolitical tensions and supply-chain challenges amplified during the pandemic. As demonstrated in the chart below2, domestic manufacturing investments have grown exponentially since 2022, increasing productivity, bringing jobs back to the U.S. and reducing our reliance on fossil fuels.

Inflation and Fed Policy

Although the Fed paused interest rate hikes in June for the first time in 15 months, Chairman Powell reiterated in his testimony to Congress that the Fed is committed to bringing inflation down towards its 2 percent target, and he hinted that the Fed expects additional hikes later this year. While headline inflation has indeed improved materially since the highs reached one year ago, core inflation remains stubbornly high (core inflation excludes the prices of food and energy, which tend to be more volatile). The longer inflation remains, the more entrenched it becomes, and the more difficult it is to remove. The geopolitical factors mentioned above and the consequences on global trade are likely to complicate the inflation picture going forward.
In short, the Fed remains in a difficult position. It needs to fine-tune policy to try and slow the economy enough to quell the inflationary pressures without tightening so much that the economy deteriorates quickly or exacerbates the banking challenges create by the higher rates we saw earlier this year. Up to this point, the Fed has walked the tightrope almost perfectly. Let’s hope that continues.

Equities

Despite the broad array of uncertainties, equity markets had their best first half in nearly 40 years. After a relatively modest start, equity markets were supercharged higher following the second-quarter earnings reported by NVIDIA, a manufacturer of graphic chips, high-performance computing and AI.

As discussed previously, technological advancements can improve productivity and, in the case of NVIDIA, create a significant surge in investment and potential earnings growth. To put this in perspective, revenue growth for the S&P 500 has averaged 4.18% going back to the year 2001, while consensus analyst expectations for NVIDIA’s revenue growth is 60% over the next 12 months, which is incredible on its own, but even more so when you take into consideration that NVIDIA is the sixth-largest company in the world by market cap. Further, while the benefits of technology are something we’ve discussed in the past, this is the first time we are seeing the actual results show up in revenue and earnings to this degree.

While stocks indeed started the year off strong, we’d be remiss if we didn’t address the fact that the market has essentially been dragged higher by a handful of technology companies. If you remove these companies, returns for the balance of the market were relatively flat until recent weeks.

To try and gauge where returns could be headed, we can process and break down returns into earnings growth, valuations and dividends. Looking at current expectations for earnings, consensus expectations call for 0.8 percent year-over-year growth for the third quarter of 2023. If we continue to use consensus earnings as a guide, we could start to see a pick-up in the fourth quarter with 8.2 percent growth year-over-year, and 12.3 percent earnings growth for 2024 compared to 2023. Valuations remain broadly a bit stretched, with the Forward Price to Earnings ratio currently 12.5 percent above the 25-year average. If you remove the large tech companies that have driven markets year to date, the forward P/E is effectively at that average.

Fixed Income

After one of the worst years on record for bond investors, fixed-income returns were more palatable at the start of 2023. The takeaway from the current fixed-income environment is that the yield curve is extremely inverted. This means that yields on short-term bonds are well above that of longer-term bonds, suggesting that bond investors do not expect inflation to stick around longer than a couple of years. Further, if we look at credit spreads, the additional yield that riskier bonds pay above government bonds remains fairly low. Given these dynamics, we would continue to recommend a short-term positioning in your fixed-income exposure with a focus on higher-quality bonds.

Outlook
Base Case Scenario
Inflationary pressures continue to moderate, allowing the economy to avoid severe recession and corporate earnings to end up in line with consensus expectations. Considering where equity valuations are today and the lagged effects of monetary policy, it would be reasonable to assume that valuations, at a minimum, remain at the level they are today with dividends staying at their 25-year historical average. Under this scenario, we would expect returns of 9.8 percent.
Earnings + 7.8% + Valuations 0% + Dividends 2% = 9.8%
Optimistic Scenario
Despite rapid Fed tightening, the economy avoids a recession and even picks up pace due to advancements and significant investments in artificial intelligence and renewable energy. The resulting optimism could push valuations 10 percent above their currently high levels. The increase in economic growth and productivity would give corporate earnings a boost to 9 percent with dividends coming in at the historical 2 percent. This results in a total expected return of 21 percent.
Slow and Flat Transition Scenario
The strong labor market allows the economy to avoid recession, but restrictive monetary policy in place causes the economy to grow at a snail’s pace. Technological advancements adds to the economy, but the recent rally in equity markets essentially pulls that growth forward. Under this scenario, we’d expect earnings growth to come in 5.9 percent, for valuations to move towards their long-term average and decline by 12.5 percent, and for dividends to remain at 2 percent. This results in a total expected return of -4.6 percent.
Pessimistic Scenario:
Despite general optimism over productivity gains, the broader economy eventually succumbs to the Fed’s restrictive monetary policy. After showing remarkable resilience, unemployment rises significantly, and the economy does enter a recession. Under this scenario, we would expect corporate earnings to come in at half the current rate to 3.9 percent, for valuations to move below their long-term average and decline 15.8 percent, and assume a reduction in dividends to 1 percent. This scenario produces a total return of -10.9 percent.

Conclusion

While the U.S. economy is still very much in a transitional phase, battling pesky inflation and a broad range of geopolitical uncertainties, it is difficult to suppress optimism over the U.S.’s future. No other country in the world innovates like the U.S. or has the legal system in place to protect private property rights and encourage investment. The restrictive monetary policy in place could lead to some economic weakness this year, but the incredible resilience of the economy up to this point proves the economy is stronger than many expected.
As always, we will continue to keep a close eye on how these developments evolve.
Sources:
  1.   McKinsey & Company, “The Economic Potential of Generative AI,” June 2023
  2.   St. Louis Federal Reserve
About the Author: Joseph Karl, CFA, is chief investment strategist with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email info@provwealth.com.
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Joseph Karl, CFA, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors + CPAs. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
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The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary.
There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Past performance may not be indicative of future results. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. The above hypothetical examples are for illustration purposes only. Actual results will vary. Future performance cannot be guaranteed, and investment yields will fluctuate with market conditions. Diversification does not ensure a profit or guarantee against a loss.

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