May 5, 2023
The second quarter of 2023 is off to an interesting start. For the most part, investment markets performed well in April and first quarter earnings season is shaping up better than expected. Meanwhile, consensus expectations for the economy portend a high likelihood of a recession in the next 12 months, and our preferred indicators support this view as well. Looking forward, we believe geopolitics and monetary policy will carry the greatest influence over how the rest of the year transpires for the economy and the markets.
Investment markets built on year-to-date gains in April. In the month of April, global equities gained 1.3%. U.S. stocks added 1.3% while developed international stocks rose 2.8% and emerging market stocks fell 1.1%. Year-to-date, global equities are up 8.4% with domestics (+8.6%), developed international (+11.5%) and emerging markets (+2.8%) all showing gains. Bonds returned 0.6% for the month as the U.S. 10-year Treasury yield retreated 5 bps to 3.42%. Year-to-date, core bonds are up 3.0% with the U.S. 10-year Treasury yield down 45 bps.
First quarter earnings season is off to a relatively strong start. With 53% of S&P 500 constituents reported, corporate earnings are tracking to a blended decline of 3.7%. This compares favorably to expectations for a decline of 6.7% when the quarter ended. Analysts are currently forecasting a 5.0% earnings decline in the second quarter, followed by growth of 1.7% and 8.8% in the third and fourth quarters and 1.2% earnings growth for the full year.
Shifting to the economy, an initial look at U.S. GDP showed annualized growth of 1.1% in the first quarter, marking deceleration from annualized growth of 2.6% in the fourth quarter of 2022. As it stands, 65% of economists believe the U.S. will enter a recession at some point in the next 12 months, while a model produced by the New York Federal Reserve calculates the probability at around 58%. If it happens, it will be the most widely anticipated recession in history.
Our primary recession indicators, among the many we monitor, suggest an elevated likelihood of a recession as well. Unemployment remains historically low at 3.5%, but monthly payroll additions have moderated of late, job openings appear to be on the decline, and workforce reductions are increasingly prevalent in the headlines. Meanwhile, retail spending appears to be losing momentum with an inflation adjusted decline of more than 2% in March. The yield curve remains sharply inverted with short-term interest rates meaningfully higher than long-term interest rates.
While many variables, known and unknown, will influence the timing and depth of the next recession, we believe geopolitical risks and monetary policy decisions will heavily influence the near-term path of the economy and markets.
The geopolitical landscape is complicated, with issues ranging from an ongoing war between Russia and Ukraine to tensions between the US and China. In Washington, brinksmanship over the US debt ceiling continues to fuel anxiety. House Republicans recently introduced a bill that would cut federal spending in exchange for lifting the ceiling for one year. The legislation is unlikely to succeed in the majority Democrat Senate in its current form but could provide the basis for eventual negotiations. All of these concerns are notoriously difficult to evaluate.
Turning to monetary policy, by the time this article goes to print, the FOMC will likely have delivered a third consecutive quarter point rate increase at its May meeting bringing the Fed funds rate to a range of 5.00%-5.25%. Market participants are pricing for rate cuts in late 2023 and early 2024, though policymakers have yet to concede that narrative. With expectations for relatively slow growth, a gradual rebalancing of supply and demand in the labor market and inflation moderating, committee members don’t foresee rate cuts this year. Even so, a 5.00% terminal rate is lower than the peak expectation of 5.50%-5.75% just prior to regional bank failures in March. Deposit flows continue to be negative across the banking sector, moving primarily toward money market mutual funds, and we will be monitoring the extent to which this tightens credit conditions throughout the rest of the year.
The year-to-date experience is a prime example that while it may be easy to identify risks and issues facing the economy and financial markets, it is impossible to consistently predict their timing, magnitude and interdependence. Throw in a couple of unforeseen variables and any semblance of a crystal ball is quickly dashed. We expect the same to be true in the balance of 2023 and continue to rely on the key tenets of our investment philosophy to guide us through the conditions we find ourselves in.