October 6, 2023
Market Summary
The economy has proven stronger and more resilient this year than we expected. We misjudged the cushion of savings built up during the pandemic that has allowed consumers to maintain their spending habit for far longer than might have been expected in the face of such a rapid rise in interest rates. Combined with a substantial moderation in inflation, it has lent credence to the hopeful view that the Federal Reserve (“Fed”) will be successful in engineering a soft landing, helping to propel the stock market higher this year. However, surging bond yields, due in part to improving economic momentum, caused stocks to retreat during the third quarter, and this pullback has continued into the new quarter.
As we highlighted last quarter, the stock market remains a bifurcated one this year with most of the S&P 500’s gains provided by just a handful of megacap technology stocks. In fact, 85% of the S&P’s year-to-date gains (up from 75% a quarter ago) have been provided by just seven stocks – Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla (aka the “Magnificent Seven”). After racing well ahead of the equal weighted indices in the first half of the year, the market cap weighted indices fell less than the equal weighted ones in the most recently completed quarter. Unfortunately, the highly concentrated nature of the gains this year has made it extremely difficult for more diversified strategies to keep up. We don’t believe this is a sustainable situation, and would expect that as the market broadens out a diversified portfolio of high-quality growth stocks should benefit.
Due to stronger than expected consumer spending, economic growth forecasts for both the third quarter and full year 2023 have been revised higher. The Atlanta Fed’s closely-followed GDPNow model currently estimates Q3 real GDP growth (seasonally adjusted annual rate) of +4.9%, up from +1.7% and +2.4% in the preceding two quarters. We now expect full year 2023 real GDP to grow by more than 2%. This compares to prior expectations closer to +1%. At the same time, inflation, as measured by the consumer price index (CPI), has fallen from a peak of nearly 9% year-over-year in the summer of 2022 to 3.7% year-over-year as of the most recent reading. We estimate that both headline and core CPI will likely exit this year at about +3.5% y/y, still well-above the Federal Reserve’s +2% long-term target.
Consistent with the lift in Q3 GDP estimates, we would expect Q3 earnings, set to be reported in coming weeks, to be reasonably decent, perhaps showing a return to positive year-to-year growth after three quarters of declines. We would further anticipate that better than expected Q3 earnings will likely bolster investor confidence that the current consensus expectation for a return to double-digit EPS growth in 2024 is achievable. However, we continue to harbor doubts about this view. While recession may have been deferred this year, we don’t believe it has been averted. We remain mindful of the extent of the Fed’s tightening actions over the past 18 months with their typical long and variable lags. We also remain cognizant of how difficult of a balancing act it is for the Fed to perfectly time its withdrawal of monetary restraint, which is why its track record for navigating soft landings is so poor.
Beyond the usual suspects of early, and historically-reliable, recession warning signs we have already observed this year – an inverted yield curve, contracting money supply, declining leading economic indicators, falling manufacturing PMIs, and tightening bank credit – we would note the two-headed monster of rising bond yields and rising oil prices, which together should take a growing toll on households and businesses alike, acting as a headwind to economic growth. We would further note that these headwinds come at a time when consumers are already facing other spending constraints, including the near exhaustion of pandemic-era savings, the resumption of student loan payments, rapidly rising credit card balances (along with a significantly higher cost for that credit), and slowing job and wage gains.
We also expect higher home mortgage and auto loan rates will result in ongoing subdued activity in those two sectors. The housing and auto sectors are normally two major drivers of the economy. Partially offsetting this, higher federal spending on public infrastructure as well as subsidies for green energy and domestic semiconductor manufacturing should be supportive of growth. However, mounting government deficits and the cumulative expansion in the federal debt at a time when there is less demand for U.S. government bond issuance from foreigners – the Chinese in particular – and our own Federal Reserve are putting pressure on bond yields and crowding out private investment.
Even though we believe the Federal Reserve is likely nearing the end of its rate hiking cycle, monetary policy is likely to remain tight for an extended period. In its resolve to convincingly bring inflation back down to its 2% target, the Fed likely maintains rates higher for longer. At the same time it will continue to reduce the size of its balance sheet (Quantitative Tightening), drawing liquidity out of the economy. Thus, the Fed is not yet our friend. More importantly, what’s left now is for the lagged effect of the Fed’s prior rate increases to fully impact economic activity.
Economic Outlook
We continue to expect heightened market volatility in the near term. The market remains fully valued based on our work; investor sentiment, while improving, remains too complacent; and earnings estimates remain at risk as future growth is likely to disappoint and corporate profit margins are further pressured. Positively, we are nearing the tail-end of the typically more challenging May-to-October seasonal trading period. November-to-April is usually a friendlier time for equity investors.
We remain of the opinion that we are late in the economic cycle and thus high-quality growth is likely to prove the best place to be for stock investors. We currently have over 80% of our clients’ assets invested in high quality stocks, which we define as those rated ‘A’ or ‘B’ within our proprietary ranking system used to assign discount rates for valuation purposes. These are companies characterized by consistent, above-average growth in earnings, free cash flow and dividends, high profit margins and returns on equity, and low financial leverage. We would expect these stocks to provide investors relative safe harbor amidst choppy seas.