2023 H2 Market Outlook: Silver linings amid economic headwinds

17 July 2023
Stephanie Leung
CIO Office

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Challenges remain on the horizon, but a painful past year has set up better returns in the future

At the start of 2023, most investors shifted their focus from high inflation to weak growth, with increasing expectations of developed market (DM) economies like the US and Europe falling into recessions.

But we’re now halfway through the year, and the global economy is still rolling with the punches (though it is slowing). This is despite rapidly rising interest rates, mini banking sector crises in the US and Europe, and a standoff over the US debt ceiling. Meanwhile, equity markets in particular are roaring, though this has been largely lifted by excitement over the tech sector (and specifically, artificial intelligence).

As we move into the second half (H2) of 2023, we dig deeper into what’s keeping the world’s biggest economy afloat, and why we still think there are challenges ahead. We also take a step back to look at the bigger, longer-term picture, and why we believe it paints a brighter future for investor returns.

Here are our main takeaways:

  • The strength of the US labour market – as the result of post-pandemic supply-demand imbalances – is keeping the US economy afloat. It’s also the key reason why interest rates have not come down. As the labour market gradually normalises with the aid of Fed’s rapid rate hikes, we expect both inflation and growth to soften. These hikes are also why a recession is still likely, especially as the Fed pushes interest rates further above 5%.
  • The recent jump in interest rates comes after 40 years of steady decline. During that period, long-term US government bond yields fell 20 basis points (bps) on average per annum – that’s equivalent to a 6% return tailwind in terms of capital appreciation. This big reset in the bond market – a roughly 200 bps increase in bond yields over the past year or so – potentially creates another 10 years of runway for returns, assuming rates fall at a similar pace in the long-term. Likewise, falling discount rates have also provided strong tailwinds for equities.
  • Elsewhere, Europe faces similar challenges, while China is still struggling with recessionary conditions. Japan may be one the few bright spots as the economy is showing signs of emerging from long-term deflation.
  • Our investment framework, ERAA®, continues to signal that we’re in a stagflationary economic regime. Given the challenging macro environment over the next 6 to 12 months, we’ve maintained our asset allocations – short-duration bonds, defensive equities, and gold continue to play key roles in our portfolios.

The resilience of the US labour market may draw out the timing of an eventual recession

The central debate for investors this year has been whether the US will be able to avoid a recession. In our view, how long the US labour market can withstand the pressure of the Fed's fastest rate hikes since the 1980s is the key to answering this question.

That’s because the jobs market has remained much tighter than expected – resulting from a combination of supply-demand imbalances related to the post-pandemic reopening and structural shifts in the economy.

The US labour market is key to both growth and inflation outlooks

The strength of the labour market is important for growth because consumer spending is a significant driver of economic activity – accounting for roughly 70% of US GDP. And retail consumption has been particularly strong over the past few years. This comes from the fact that households had built up significant “excess savings” during the pandemic, with governments doling out fiscal stimulus and locked-down consumers having nowhere to spend it.

Spending on goods, like computers or furniture, boomed during the pandemic, but has been coming back down to its pre-Covid trend. It’s the services sector that’s still going strong, as consumers have shifted their spending to the experiences they were unable to partake in over the past few years – think plane tickets or concerts (Taylor Swift, we’re looking at you).

This strong demand for services comes at a time when the US is facing a labour shortage, partly due to a reshuffling of the jobs market during the pandemic. But it’s also due to other longer-term forces like the baby boomer generation moving into retirement – a trend that was accelerated by the pandemic. As labour force participation dropped, that resulted in a workforce that has nearly 2 million fewer workers than if the pre-Covid participation rate had been sustained.

These dynamics are putting upward pressure on wages and are keeping service prices elevated – especially as companies have been able to pass on higher costs for labour and other inputs to consumers. In fact, in recent months, services inflation has been the main contributor to overall inflation, with the latest reading of 6.2% year-on-year in June well above the headline reading of 3%.

Ultimately, we believe the impact of these forces will gradually fade as job figures move back towards equilibrium – but as of now, the resilience of the labour market may push out the timing of an eventual downturn.

Fed tightening will ultimately weigh on the economy

On balance, these forces are also likely to prompt the Fed to keep interest rates higher for longer in order to cool down the labour market and avoid the kind of wage-price spirals that led to persistently high inflation in the 1970s-80s. This further increases the probability of a recession in the period ahead, especially as the Fed has signalled it has one to two more rate increases in store this year.

There are risks to our baseline scenario, to both the downside and upside:

  • On the downside, if energy or other commodity prices rise sharply – for example, due to a stimulus-driven pickup in China, or an escalation in geopolitical tensions – inflation may pick up again, forcing the Fed to hike further than the market currently expects.
  • There is also the upside risk of a “soft landing”; if monetary conditions are "just right” as the labour market gradually cools, that could result in a Goldilocks scenario in which the economy is able to avoid recession. But based on the evolving situation, this requires some very timely manoeuvres from the Fed.  

Recent challenges could set us up for better returns in the longer-term

At StashAway, one of our core beliefs is that taking a longer-term perspective toward investing is essential to building wealth. Especially considering the markets’ ups and downs over the past few years, we think it’s useful to take a step back and look at where we’ve been. Indeed, a look at the broader trends of the past few decades reveals the bigger picture, providing a preview of what could be in store ahead.

Four decades of falling interest rates were a big support for bond returns 

Until very recently, the US bond market had been in a 40-year bull market that started in the early 1980s. That was when the Fed last deployed aggressive interest rate hikes to tame inflation, during which the fed funds rate peaked at 20%. 

After the Fed declared victory in its battle against inflation back then, interest rates (and bond yields) have been on a long-term downtrend, with yields on long-term US Treasuries decreasing by about 20 bps per year over the last four decades. This fall in yields was the result of a number of forces, including slowing economic growth, well-contained inflation expectations, demographic and technological changes, and unconventional monetary policies like quantitative easing (QE). Importantly as well, the starting point for interest rates then was north of 10%.

Recall that bond prices have an inverse relationship with yields, so the price appreciation from falling yields has been positive for total bond returns. During that period, long-term government bonds posted total returns of more than 17x, or annual returns of 7.5%. 

It’s important to note though, since bond yields have declined over the past 40 years, total bond returns – which incorporate both yield and price movements – have diminished over time.

A great reset after the biggest bond bear market in history

This dynamic has shifted over the past year or so, as the Fed rapidly hiked interest rates to combat the highest inflation since the 1980s. Those hikes resulted in one of the biggest bear markets for bonds in history, with the aggregate US bond market down 13% last year.

But this has also created a great reset for bonds, with a 200-300 bps jump in yields bringing them back to levels last seen in the early 2010s. This is important – it means that bond returns could have another 10-year runway if yields continue to trend back down in the years ahead.

Low rates have also been a strong tailwind for equity returns

It’s a similar story for equities. Over the last 40 years, the US equity market has posted strong performance, with the S&P 500 up 81x. That’s equivalent to returns of 11.5% per annum. Falling interest rates have also been supportive of equities, as a lower discount rate increases the present value of future cash flows.

In addition, the launch of QE after the 2008 global financial crisis significantly increased liquidity in the financial system, which had the effect of suppressing bond yields and keeping real interest rates below 0%, making it profitable for companies to borrow and invest. 

These forces drove investors into relatively riskier assets like stocks, and contributed to the asset class’s significantly stronger relative returns since 2010. The last 40 years have shown the power of compounding returns and the importance of staying invested through the markets’ ups and downs.

Outside the US, China faces a recession while Japan is a bright spot

Elsewhere in the world, we continue to see a different set of dynamics playing out.

The picture in Europe is similar to the US, with inflation (and especially core inflation) remaining stubbornly high. That’s prompting the European Central Bank and the Bank of England to push forward with additional rate hikes this year.

In China, the economy’s recovery has faltered, as slowing growth overseas weighs on exports, and the end of its zero-Covid policy has not resulted in the expected boost to consumer spending. Here, deflation is a bigger concern as high debt levels and continued weakness in the property sector continue to weigh on the economy’s prospects.

As a result, China’s central bank is moving in the opposite direction as much of the rest of the world – with rate cuts, rather than hikes. China's key constraint however, is that it is unlikely to conduct large scale stimulus given the government’s long-term policy goal of debt deleveraging.

Japan is one of the few bright spots among major economies, as the Bank of Japan is the only major global central bank that is actively pushing a loose monetary policy as it works to bring inflation consistently up to its 2% target. Although recent gains in that market have diminished short-term prospects, potential structural reforms to lift corporate returns can drive further growth in the long-term.

ERAA® shows we’re still in stagflation, and our portfolios remain positioned to navigate uncertainty

At the end of 2022, our investment framework, ERAA®, signalled a shift from inflationary growth to stagflation – an economic regime where growth is contracting and inflation is elevated (but slowing). It positioned our portfolios more defensively to ride out the market uncertainty that’s typically associated with this regime. 

The latest readings from ERAA® show that US growth is still in contraction while inflation continues to come down. But core inflation – which is a measure of “stickier” underlying price pressures – is proving to be a tough nut to crack. Given the high level of uncertainty over how growth and inflation dynamics could play out in the near-term, this means that staying on the defence will continue to be the best offence.

Maintaining our defensive asset allocations

Short-duration bonds remain attractive given their high yields and low risk. US Treasury bills, for example, now yield upwards of 5.3% per annum –  up from about 4.5% at the start of the year. The potential for additional Fed tightening means yields may increase even further in the months ahead. On the other hand, longer-duration bonds stand to gain when the economy slows, historically benefiting towards the end of central bank tightening cycles.

Putting the question of a recession aside, the bottom line is that growth is still poised to slow – which will ultimately weigh on company earnings. Defensive sectors are more likely to outperform in this environment. Alongside this, we’re maintaining a slight overweight allocation to technology stocks as the sector sees tailwinds from recent breakthroughs in AI.

Global equities outside the US provide good opportunities for diversification as economic cycles continue to diverge. In particular, exposure to Japanese stocks can capture the economy’s more favourable growth dynamics.

Gold continues to have a key place in our asset allocations, as its low correlation to other asset classes means it provides protection during uncertainty. We saw this dynamic play out in H1, with gold benefitting from a flight to safety amid banking crises.

It’s time in the market, not timing the market, that builds wealth 

It’s extremely difficult to time the market – even the most experienced professional investors don’t always get it right.

Let’s look at recent events: most investors (admittedly, ourselves included) did not expect the 40%-plus boom in big tech in H1, and the resulting rally of US equities. But by maintaining a diversified portfolio and an overweight allocation to tech (as our ERAA® regime calls for), we were still able to benefit from the rally (we’ll talk about this more in our H1 performance review). This illustrates that while timing the market is difficult, staying invested is a much better strategy, especially as the prospect for longer-term returns looks brighter.

That’s why we’re strong advocates of dollar-cost averaging; regularly investing in the markets is one of the best ways to grow your wealth and reach your financial goals. Think of it as a sailor navigating the oceans: though shifting winds may change the original course that was charted – the ultimate destination is always kept in mind.

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