A soft landing?

by Badgley Phelps | Aug 21, 2023

Outlook: 3rd quarter 2023

Economy

Despite widespread pessimism at the outset of the year, the economy is currently on a path to a soft landing. The economy has been remarkably resilient, with growth of 2.4 percent in the second quarter, declining inflation, and a historically low unemployment rate.

While we are on a path of modest growth, this environment is unusual. The expansion has been uneven, with some industries experiencing exceptionally strong demand and others contracting. This is a function of the pandemic and the associated closure of parts of the economy. At the height of the pandemic, people stayed in their homes, and demand for goods was exceptionally strong while many service-related businesses were closed. Today, we are seeing a reversal of those trends with demand for some goods contracting while service-related industries, such as travel and restaurants, are experiencing a dramatic revival.

Looking forward, we expect the economy to continue along its current uneven path, culminating in modest growth rates. It will take time for demand trends to normalize, and there are several driving factors that are working to offset one another. Inflation is falling, and employment markets remain resilient, which suggest the economy can continue its expansion. However, growth is likely to be tempered as the Federal Reserve continues to pursue a tight monetary policy and consumers are working through the savings they built during the pandemic.

Inflation

Inflation remains elevated but has fallen significantly from last year’s peak. The Consumer Price Index increased at an annual rate of 3.0 percent in June, and the core measure, which excludes the volatile food and energy components, increased by 4.8 percent. This marks the lowest level for the headline number since March 2021.

Looking forward, we expect inflation to continue its downward trend. However, the key question remains where it will settle on a long-term basis. In the years leading up to the pandemic, the Consumer Price Index increased at an annual rate of approximately 2.0 percent, but at this stage, it remains unclear if the rate can return to that level without a meaningful downturn in the economy.

U.S. dollar

The U.S. dollar traded at a high level throughout most of 2022. However, expectations for an end to the Federal Reserve’s rate increases have driven our currency from last year’s peak. Despite this decline, it is above its long-term average, and we expect the dollar to maintain its downward bias as the Federal Reserve shifts away from its policy of raising rates.

Asset class

Cash/Money Market Instruments

After a pause in June, the Federal Reserve raised rates in July by an additional 25 basis points to a range between 5.25 and 5.50 percent. The quarter-point increase resulted in the highest Federal Funds rate in 22 years. There have been eleven rate hikes in this interest rate cycle and yields on money market funds have adjusted accordingly. They currently stand at their highest levels of the year, hovering around 5.0 percent. While economic activity continues to surprise on the upside, the Consumer Price Index report from the month of June indicated that inflation is falling with a decline from 4 to 3 percent. Inflation is expected to continue to moderate, and accordingly, the consensus forecast is calling for, at most, one more rate hike for this interest rate cycle.

Intermediate Government/Credit Bonds

Consistent with the latest economic data that reveals stronger than expected economic growth with a cooling inflation trend, hopes for a soft landing have revived, and that has been priced into credit spreads. Optimism related to averting a recession has led to tightening spreads in both high yield and investment grade bonds. High yield spreads of 370 basis points over a comparable Treasury reflect the tightest level year-to-date and a demonstrable improvement from the 516 basis point high at the peak of the regional bank crisis. Similarly, the investment grade spread at 117 basis points is close to the low for the year and is roughly 0.5 percent below the high posted during the volatile March period.

Tax-Exempt Municipal Bonds

In tax-exempt bonds, the theme of inadequate supply has become all too familiar. Year-to-date, supply is 16 percent below last year’s pace. Texas continues to lead the pack in new issue volume. In July, Texas accounted for nearly one third of all new issuance and brought to market more bonds than the second (CA) and third (NY) leading states combined. Short-term yields are undoubtedly attractive, but with the Federal Reserve nearing the end of its rate hiking campaign, we are focusing new purchases on locking in intermediate to long term yields.

U.S. Equity

The S&P 500 Index generated a strong gain in the first half of the year. However, a closer look at the underlying constituents reveals that the market’s returns were bifurcated. The largest stocks in the Index were the drivers of the return as the eight largest positions increased by an average of more than 80 percent. These stocks rose dramatically as they are expected to benefit from the proliferation of artificial intelligence. In contrast, many other stocks generated modest gains or declined as evidenced by the fact that strategies utilizing equal weights for index constituents significantly underperformed the traditional capitalization-weighted indexes.

In the second half of the year, we are watching for greater symmetry in the returns of each market segment. The economy has settled into a soft landing characterized by an uneven expansion. Some industries are benefiting from strong demand while others are in, or close to, a recession. Demand patterns will normalize over time, and in anticipation of that trend, we expect more broad participation in the market rally.

International Equity

International equities also participated in the rally this year. In aggregate, returns were strong driven by good performance in European, Japanese, and Latin American markets. This year, stocks in the developed markets have outperformed those in the emerging economies as growth in China has been lower than expected.

Looking forward, we expect international equities to follow the lead of the U.S. markets. Many of the fundamental issues are similar worldwide, including high inflation rates, restrictive central bank policies, and disparate rates of growth across industries. However, the valuations on foreign stocks are attractive by historical standards and the forward P/E ratios are much lower than those on domestic equities. An additional tailwind may be provided by a decline in the U.S. dollar.

Commodity

Commodity prices generally declined in the first half as reflected by falling inflation rates. Prices in the energy segment declined, and gold prices increased on fears of slowing global growth, recessionary concerns, and expectations for a peak in central bank policy rates.

Looking forward, we see a mixed picture in the near term as a slowing economy should result in lower demand and a general softening in prices. However, the extent of the declines may be tempered by ongoing supply constraints related to the war in Ukraine and a low level of investment in production capacity for some commodities. On a longer-term basis, we remain constructive on commodities, given ongoing supply headwinds across many of these markets.

Potential opportunities & risks

Opportunities

New opportunities/new markets—The outbreak of COVID-19 presented a unique set of challenges. It also provided businesses with an opportunity to differentiate and develop new markets. According to some estimates, technology has been pulled forward two to three years and new products and services are in high demand.

Despite a push for a return to the workplace, many people are resisting that pressure and continue to advocate for flexible work policies. The ongoing demand for remote work opportunities increases the demand for technologies that can facilitate a world of geographically distanced employees. In addition, a shortage of labor is leading companies to invest in technology with the goal of boosting productivity, automating processes, and adapting to the lack of labor supply.

The emergence of new technologies—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, and cloud computing.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.

Risks

Recession—The unprecedented tightening of monetary policy since March of last year has increased the risk of a recession. The Federal Reserve has reversed course from an aggressive stimulus policy to a tightening stance in a short period of time. Monetary policy works with a lag of about one year, so we are just beginning to feel the impact of the initial rate hikes in 2022. Accordingly, it is possible the central bank has tightened too aggressively, resulting in a hard landing for the economy and a recession in 2024.

Inflation—Given the unparalleled amount of fiscal and monetary stimulus in previous years, the war in Ukraine, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a shortage of labor, there is a risk that inflation may remain above the average of the last thirty years.

Rising Government Debt—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt has increased approximately 43 percent since the end of 2019 and that trend shows no sign of reversing course. While the short-term implications of higher debt levels are manageable, the long-term implications may be substantial as rising interest costs burden taxpayers.

Deglobalization—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, and a rising cost structure for some industries.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring developments in the war between Russia and Ukraine as well as relations between the West and China.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.

 

Originally posted on August 22, 2023

Subscribe to Our Blog

  1. Email address is required.
    You have entered an invalid email address.
  2. First name is required.
  3. Last name is required.
Subscribe

Search Our Blog

Recent

A soft landing?

by Badgley Phelps | Aug 21, 2023

Outlook: 3rd quarter 2023

Economy

Despite widespread pessimism at the outset of the year, the economy is currently on a path to a soft landing. The economy has been remarkably resilient, with growth of 2.4 percent in the second quarter, declining inflation, and a historically low unemployment rate.

While we are on a path of modest growth, this environment is unusual. The expansion has been uneven, with some industries experiencing exceptionally strong demand and others contracting. This is a function of the pandemic and the associated closure of parts of the economy. At the height of the pandemic, people stayed in their homes, and demand for goods was exceptionally strong while many service-related businesses were closed. Today, we are seeing a reversal of those trends with demand for some goods contracting while service-related industries, such as travel and restaurants, are experiencing a dramatic revival.

Looking forward, we expect the economy to continue along its current uneven path, culminating in modest growth rates. It will take time for demand trends to normalize, and there are several driving factors that are working to offset one another. Inflation is falling, and employment markets remain resilient, which suggest the economy can continue its expansion. However, growth is likely to be tempered as the Federal Reserve continues to pursue a tight monetary policy and consumers are working through the savings they built during the pandemic.

Inflation

Inflation remains elevated but has fallen significantly from last year’s peak. The Consumer Price Index increased at an annual rate of 3.0 percent in June, and the core measure, which excludes the volatile food and energy components, increased by 4.8 percent. This marks the lowest level for the headline number since March 2021.

Looking forward, we expect inflation to continue its downward trend. However, the key question remains where it will settle on a long-term basis. In the years leading up to the pandemic, the Consumer Price Index increased at an annual rate of approximately 2.0 percent, but at this stage, it remains unclear if the rate can return to that level without a meaningful downturn in the economy.

U.S. dollar

The U.S. dollar traded at a high level throughout most of 2022. However, expectations for an end to the Federal Reserve’s rate increases have driven our currency from last year’s peak. Despite this decline, it is above its long-term average, and we expect the dollar to maintain its downward bias as the Federal Reserve shifts away from its policy of raising rates.

Asset class

Cash/Money Market Instruments

After a pause in June, the Federal Reserve raised rates in July by an additional 25 basis points to a range between 5.25 and 5.50 percent. The quarter-point increase resulted in the highest Federal Funds rate in 22 years. There have been eleven rate hikes in this interest rate cycle and yields on money market funds have adjusted accordingly. They currently stand at their highest levels of the year, hovering around 5.0 percent. While economic activity continues to surprise on the upside, the Consumer Price Index report from the month of June indicated that inflation is falling with a decline from 4 to 3 percent. Inflation is expected to continue to moderate, and accordingly, the consensus forecast is calling for, at most, one more rate hike for this interest rate cycle.

Intermediate Government/Credit Bonds

Consistent with the latest economic data that reveals stronger than expected economic growth with a cooling inflation trend, hopes for a soft landing have revived, and that has been priced into credit spreads. Optimism related to averting a recession has led to tightening spreads in both high yield and investment grade bonds. High yield spreads of 370 basis points over a comparable Treasury reflect the tightest level year-to-date and a demonstrable improvement from the 516 basis point high at the peak of the regional bank crisis. Similarly, the investment grade spread at 117 basis points is close to the low for the year and is roughly 0.5 percent below the high posted during the volatile March period.

Tax-Exempt Municipal Bonds

In tax-exempt bonds, the theme of inadequate supply has become all too familiar. Year-to-date, supply is 16 percent below last year’s pace. Texas continues to lead the pack in new issue volume. In July, Texas accounted for nearly one third of all new issuance and brought to market more bonds than the second (CA) and third (NY) leading states combined. Short-term yields are undoubtedly attractive, but with the Federal Reserve nearing the end of its rate hiking campaign, we are focusing new purchases on locking in intermediate to long term yields.

U.S. Equity

The S&P 500 Index generated a strong gain in the first half of the year. However, a closer look at the underlying constituents reveals that the market’s returns were bifurcated. The largest stocks in the Index were the drivers of the return as the eight largest positions increased by an average of more than 80 percent. These stocks rose dramatically as they are expected to benefit from the proliferation of artificial intelligence. In contrast, many other stocks generated modest gains or declined as evidenced by the fact that strategies utilizing equal weights for index constituents significantly underperformed the traditional capitalization-weighted indexes.

In the second half of the year, we are watching for greater symmetry in the returns of each market segment. The economy has settled into a soft landing characterized by an uneven expansion. Some industries are benefiting from strong demand while others are in, or close to, a recession. Demand patterns will normalize over time, and in anticipation of that trend, we expect more broad participation in the market rally.

International Equity

International equities also participated in the rally this year. In aggregate, returns were strong driven by good performance in European, Japanese, and Latin American markets. This year, stocks in the developed markets have outperformed those in the emerging economies as growth in China has been lower than expected.

Looking forward, we expect international equities to follow the lead of the U.S. markets. Many of the fundamental issues are similar worldwide, including high inflation rates, restrictive central bank policies, and disparate rates of growth across industries. However, the valuations on foreign stocks are attractive by historical standards and the forward P/E ratios are much lower than those on domestic equities. An additional tailwind may be provided by a decline in the U.S. dollar.

Commodity

Commodity prices generally declined in the first half as reflected by falling inflation rates. Prices in the energy segment declined, and gold prices increased on fears of slowing global growth, recessionary concerns, and expectations for a peak in central bank policy rates.

Looking forward, we see a mixed picture in the near term as a slowing economy should result in lower demand and a general softening in prices. However, the extent of the declines may be tempered by ongoing supply constraints related to the war in Ukraine and a low level of investment in production capacity for some commodities. On a longer-term basis, we remain constructive on commodities, given ongoing supply headwinds across many of these markets.

Potential opportunities & risks

Opportunities

New opportunities/new markets—The outbreak of COVID-19 presented a unique set of challenges. It also provided businesses with an opportunity to differentiate and develop new markets. According to some estimates, technology has been pulled forward two to three years and new products and services are in high demand.

Despite a push for a return to the workplace, many people are resisting that pressure and continue to advocate for flexible work policies. The ongoing demand for remote work opportunities increases the demand for technologies that can facilitate a world of geographically distanced employees. In addition, a shortage of labor is leading companies to invest in technology with the goal of boosting productivity, automating processes, and adapting to the lack of labor supply.

The emergence of new technologies—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, and cloud computing.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.

Risks

Recession—The unprecedented tightening of monetary policy since March of last year has increased the risk of a recession. The Federal Reserve has reversed course from an aggressive stimulus policy to a tightening stance in a short period of time. Monetary policy works with a lag of about one year, so we are just beginning to feel the impact of the initial rate hikes in 2022. Accordingly, it is possible the central bank has tightened too aggressively, resulting in a hard landing for the economy and a recession in 2024.

Inflation—Given the unparalleled amount of fiscal and monetary stimulus in previous years, the war in Ukraine, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a shortage of labor, there is a risk that inflation may remain above the average of the last thirty years.

Rising Government Debt—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt has increased approximately 43 percent since the end of 2019 and that trend shows no sign of reversing course. While the short-term implications of higher debt levels are manageable, the long-term implications may be substantial as rising interest costs burden taxpayers.

Deglobalization—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, and a rising cost structure for some industries.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring developments in the war between Russia and Ukraine as well as relations between the West and China.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.

 

Originally posted on August 22, 2023

Categories