August 4, 2023
If you sold in May and went away this year, my condolences. The third quarter is off to a healthy start. Investment markets performed well in July, and while second quarter earnings are down compared to a year ago (as expected), forecasts call for recovery in the second half and a strong outlook for 2024. Of course we’ve all been trained to say that the risk of a recession is elevated in the near-term. Economists have been telling us to expect a recession at some point in the next twelve months for over a year now. While some traditional indicators corroborate the concern, the possibility of a soft landing seems increasingly reasonable absent a significant misstep by the Fed or some other exogenous circumstance.
Investment markets built on year-to-date gains in July. Global equities gained 3.7%. U.S. stocks added 3.3% while developed international and emerging market stocks rose 3.2% and 6.2%, respectively. Year-to-date, global equities are up 18.1% with domestics (+20.0%), developed international (+15.3%) and emerging markets (+11.4%). Bonds returned 0.2% for the month as the U.S. 10-yr Treasury yield rose 12 bps to 3.96%. Year-to-date, core bonds are up 1.8%.
Second quarter earnings season is tracking in line with expectations. With 51% of S&P 500 constituents reported, corporate earnings are tracking to a blended decline of 7.3%. This compares to expectations for a decline of 7.0% on June 30. Of course, markets are forward-looking and they are increasingly looking forward toward and likely pricing in the 2024 earnings growth potential. Consensus expectations suggest corporate earnings could grow as much as 13% next year.
Shifting to the economy, an initial look at U.S. GDP showed annualized growth of 2.4% in the second quarter, marking acceleration from annualized growth of 2.0% in the first quarter (this figure was revised up from 1.3% as initially reported).
As it stands, 60% 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 based on the yield curve calculates the probability at around 67%. Interestingly, actual forecasts for GDP growth tell a different story. In the coming quarters, economists are forecasting 0.5% growth in Q3 and a 0.3% decline in Q4 before returning to positive GDP growth next year. Expectations have improved from a month ago when forecasts called for zero growth in Q3 and a 0.5% decline in Q4. Further, the official definition of a recession is broader than negative GDP growth, requiring “a significant, widespread, and prolonged downturn in economic activity,” which would be hard to achieve given the resiliency of the labor market.
Consistent with conventional wisdom, the working assumption for the last year and a half had been that a sharp rise in unemployment would be a necessary side-effect of tighter monetary policy aimed at reducing inflation. As policymakers embarked on the fastest hiking cycle in the last 30 years, the idea that reducing inflation and moving the labor market towards equilibrium WITHOUT raising unemployment was assumed to be all but impossible. Inflation has fallen from a peak of 9.1% last June to 3.0% last month. At the same time, job openings have come down from peak levels and quit rates have fallen. All the while the economy continues to add payrolls at a healthy clip and the unemployment rate remains near its 60-year low.
After pausing in June, the Fed moved to raise interest rates by another quarter point to a range of 5.25%–5.50% in July. While the median FOMC projection is for 5.50%–5.75% by year-end, market participants place 50/50 odds on one additional increase in 2023 with rate cuts priced in for early 2024.
None of that is to say that everything is Goldilocks. Several key metrics are trending unfavorably, albeit from strong starting points. In 2022, we avoided a recession in spite of the Russia/Ukraine war, rapid policy tightening, and a plummet in home sales. Slower growth, tighter monetary policy, and an easing though robust labor market may leave the economy more susceptible to an exogenous shock in 2023. In addition to ever-present geopolitical risks, we are keeping a close eye on the implications of student loan payments which are set to resume in October as well as the commercial real estate sector.
Payments on federal student loans have been paused since the CARES act passed in March 2020 and are set to resume in October as a result of the 2023 debt ceiling negotiations. Total additional collections are estimated at $5B–$6B per month, or $60B–$70B per year, which equates to 0.4%–0.5% of annual personal consumption expenditures. This is basically a ceiling of potential impact. Assuming every dollar that will be used to make student loan payments would have otherwise been spent (as opposed to saved, or used to pay down other debt, etc.), resumption of student loan payments could put a 0.5% dent in consumer spending. We view this as a notable, but not insurmountable, headwind for the economy.
In June, the Supreme Court found that the Biden administration did not have the authority to forgive $10,000–$20,000 for borrowers making less than $125,000, as proposed. The proposal would have forgiven roughly $430B of student loan debt for 43 million borrowers. The Biden administration has several new proposals which may limit the impact of this ruling, including (1) a 12 month “on-ramp” to payments for certain borrowers, (2) a lower-cost monthly income-based repayment program, and (3) pursuing loan forgiveness under a different federal law. It is unclear whether any of these alternative solutions will materialize or if they were to be enacted whether they would withstand legal scrutiny.
Regional banking stress appears to have stabilized, but commercial real estate could be impacted if banking stress leads to lower credit availability. Through Q1 2023, occupancy rates remained strong across the commercial real estate landscape with the notable exception of office as remote working has dragged office occupancy down to some of the lowest levels of the past 20 years. According to Nareit data based on badge swipes of workers coming to the office, the office utilization rate at the end of Q1 2023 was 50.1%, down from 99.1% in February of 2020.
Since mid-2022 prices have been falling across office, retail, and apartment properties but have remained stable in industrials. Commercial mortgage-backed security delinquencies increased in June to 3.90%, an increase of 0.70% over the prior year. Lodging (hotels) had the highest rate at 5.35%. Delinquencies remain muted by historical standards and well below the pandemic high of 10.2% in June 2020 and the all-time high of 10.3% in July 2012.
Despite an ever-changing landscape, our disciplined approach and long-term orientation serve us well as we endeavor to create comprehensive investment solutions that help our clients reach their financial goals. On behalf of the entire team, thank you for allowing us to serve on your behalf.