Is the economy near an inflection point?

by Badgley Phelps | May 04, 2023

Outlook: 2nd quarter 2023


Economic growth continues to moderate from the peak levels reached in 2021 given the sustained tightening by the Federal Reserve. The economy grew 5.9 percent in 2021 and 2.1 percent in 2022. This year, growth is expected to continue to decelerate and is likely to come in close to 1.0 percent.

The moderation in growth is a function of the Federal Reserve’s policy to fight inflation. Since March of last year, the central bank has raised rates from zero to 5.0 percent. They are also reducing the size of their balance sheet and the Federal Reserve Bank of San Francisco estimates that the combination of these two policies is resulting in an equivalent overnight interest rate of approximately 6.3 percent. In other words, the central bank has shifted from an ultra-easy stimulus policy to an aggressive tightening stance within just one year.

Given the recent stress amongst some regional banks, we expect a moderation in lending activity, and this will help the Federal Reserve in its fight against inflation. A reduction in credit growth creates a headwind for the economy. Accordingly, the Federal Reserve may be close to its peak rate for this cycle, and we expect them to pause at some point in the coming months. This will allow them to assess their progress in the fight against inflation while also pursuing financial stability.


The Consumer Price Index increased at an annual rate of 5.0 percent in March, and the core measure, which excludes the volatile food and energy components, increased 5.6 percent. This marks the ninth consecutive month the Consumer Price Index has declined, confirming our view that inflation peaked in June of last year.

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 has driven our currency from its recent peak. Despite this decline, it is above its long-term average, and we expect the dollar to remain elevated given both economic weakness in many parts of the world and heightened geopolitical risks.

Asset class

Cash/Money Market Instruments

The yield on the two-year U.S. Treasury Note peaked on March 8, at 5.1 percent, as Chairman Powell highlighted the Federal Reserve’s conviction in taming inflation during his Capitol Hill testimony. However, yields declined in the following days given stress in the banking system and fears related to financial contagion. The rate on the two-year U.S. Treasury eventually bottomed at 3.8 percent, but it has since posted a modest recovery as concerns about a systemic crisis have declined. At this stage, the overall reduction in yields represent a more cautious economic outlook and expectations for tightening lending standards that will serve as a headwind to economic growth.

The tightening of credit conditions is expected to have the same impact as additional rate hikes, thus taking pressure off the Federal Reserve to continue aggressively raising their policy rate. They raised interest rates by twenty-five basis points at their meeting in March, bringing the target range for the federal funds rate to between 4.75 percent and 5.00 percent. However, the central bank has softened the tone of their forward guidance and the language in the FOMC statement has been revised from guiding to “ongoing rate increases” to anticipating “some additional tightening”. In addition, the Federal Reserve’s expected terminal rate for 2023 was left unchanged in their most recent summary of economic projections, suggesting there will be just one more hike to bring the rate to approximately 5.1 percent. At that point the Federal Reserve is likely to pause before taking additional action so they can assess the strength of the economy and gauge the growth trajectory.

Intermediate Government/Credit Bonds

Interest rates have displayed historically high levels of volatility, largely due to concerns related to stress in the financial system. As a result of the sharp increase in interest rate volatility, credit spreads for both investment-grade and high-yield bonds widened dramatically last quarter but have since normalized as the initial fears of bank contagion have abated. At their peaks in March, the additional yield over a comparable Treasury bond widened to 165 basis points for investment grade bonds and to 516 basis points for high yield debt. Since then, both investment grade and high yield credit spreads have normalized and are only slightly elevated when compared to spreads prior to the bank contagion fears.

Overall, corporate balance sheets are generally characterized by a high level of strength and manageable near-term debt maturities, indicating that most high-quality corporate credits are prepared for a period of slowing economic growth.

Tax-Exempt Municipal Bonds

Although the interest rate outlook is decidedly mixed, municipal bonds have several positives working in their favor. Yields are above long-term averages, yet credit quality remains high as cities, counties, and school districts continue to benefit from growing property tax collections. In addition, tax-exempt bonds have historically served as haven assets in times of market disruption since they typically benefit from a flight-to-quality and low correlation with other asset classes. In short, they are better insulated than many other assets from the volatility surrounding market disruptions.

U.S. Equity

Despite the negative sentiment that was prevalent at the beginning of the year, equities generated strong gains in the first quarter. Against this backdrop, investors remain hopeful for an end to the bear market, and we continue to view it as having two stages. The first stage was characterized by a reduction in valuations from historically high levels. Markets declined last year as the Federal Reserve’s tightening campaign led investors to anticipate lower growth rates in the future. During this stage, stocks fell despite rising earnings and a continuation of the economic expansion.

This year, we expect a different environment where the trajectory of the market will largely be determined by the rate of earnings and economic growth. Inflation remains high but has been falling. In addition, the recent stress in the banking system may act as a headwind to new loan issuance and could slow the pace of the economic expansion. These factors may combine to allow the Federal Reserve to take a pause in its tightening campaign and it appears we are close to a peak in their policy rate. Given this evolution in policy, investors are shifting their focus to the real-time economic and earnings data that allow them to assess the impact of last year’s rate hikes and the recent stress amongst some regional banks.

Consensus expectations continue to suggest that earnings growth will be close to zero this year, with a strong rebound in 2024, and that remains consistent with the outlook for the economy. That outcome is known as a “soft landing” where growth is essentially flat for several quarters before resuming its upward trend. Unfortunately, the odds for a soft landing have declined somewhat with the recent stress in the banking system, but a deep recession is not a certainty. In this environment, we expect the market to remain volatile and trade close to the range established over the last twelve months.

International Equity

Many of the domestic market dynamics described above continue to impact international economies. Concerns about slowing growth, a possible recession, and high inflation are persistent throughout much of the world today. In addition, many central banks are considering an eventual shift in policy. While inflationary pressures remain high, there are some signs of a decline in their intensity.

While the risks are widely documented, some of the fundamentals for international equities have improved. In Europe, the risk of an economic shock, driven by exorbitant energy prices, has declined dramatically given a warm winter and a host of mitigation efforts that have allowed them to move away from Russia as their primary supplier of energy. In China, the government reversed its no tolerance policy against COVID-19 and the country is continuing its reopening process. That is generating a resurgence of activity and their economy grew 4.5 percent in the first quarter. The strength in China is a healthy offset to some of the slowing growth we are experiencing in other parts of the world and is helping to stabilize the global economy. At the same time, valuations for foreign stocks remain compelling as they are below the long-term average in most countries.


Commodity prices generally declined in the first quarter as reflected by falling inflation rates. In terms of the major segments, energy and agricultural prices declined but metals were mixed led by a strong increase in the price of gold.

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


New opportunities/new markets—The outbreak of COVID-19 presented a unique set of challenges. It also provided businesses with a unique opportunity to differentiate and develop new markets. By 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 to boost productivity, automate processes, and adapt 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 cloud computing, artificial intelligence, and Big Data.

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 the 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.


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 later this year.

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 de-globalization, and a shortage of labor, there is a risk that inflation may remain above the average of the last thirty years.

The debt ceiling—Our government has surpassed the statutory debt limit and our government must address this issue in the coming months. A failure to act will result in a shutdown of some government services and the possibility of delays in servicing our debt. Given the construct of the debt limit, this is an issue we have faced numerous times in the past. Consistent with the historical record, we expect a difficult process to get to a resolution, but the debt ceiling is likely to be raised.

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 41 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 May 3, 2023


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