- Consumer spending and services highlight the resilient U.S. economy. Consumer spending, nearly 70% of U.S. gross domestic product, continues to benefit from a strong labor market, rising wages and accumulated savings. The higher interest rate environment remains a headwind for consumers, especially those with higher credit balances. Higher costs are a headwind for companies, though service business surveys indicate strong activity while manufacturing remains weak, with new orders trending lower. Inflation, coupled with Federal Reserve (Fed) interest rate hikes, remain important factors. Inflation will likely slow into year-end but remain above the Fed’s 2% target.
- Developed foreign economies continue to battle inflation, with Japan a bright spot. The European Central Bank and the Bank of England are following the Fed in raising interest rates to battle their own inflationary pressures. Inflation remains elevated in this region due to strong wage gains. Business surveys indicate a manufacturing headwind, though services companies are still growing, a positive into year-end. Japan’s growth is a bright spot for the global economy, emerging from a short recession. The Bank of Japan held interest rates steady, in contrast to most major central banks, instead welcoming some reflation in their economy after decades of deflation. Japan’s economy appears likely to sustain a modest pace of real economic growth into year-end with this support.
- China’s reopening is key to emerging markets, as growth fizzled after a strong start to the new year. Business surveys indicate modest activity with little pent-up demand in new orders. Consumers’ reaccumulating of savings should support an eventual spending and growth recovery. The potential rate of growth is likely slower than the pre-pandemic economy with a greater reliance on consumption over government-driven investment. Global trade and economic activity are keys to other emerging market economies. South Korea and Taiwan are sensitive to global trade and manufacturing, where surveys indicate slowing activity and weak new order activities, so economic growth is likely to remain modest at best. Other major economies, such as Brazil, depend heavily on natural resources, where slow global economic growth is a headwind to global natural resources demand.
Market News
Q3 2023 Investment Outlook: Resilient consumers propel stocks higher
July 3, 2023
At a glance
Rumors of the global economy’s and historically riskier asset classes’ demise have so far proved premature. As consumer and business activity remain healthy, we now turn to a period where consensus estimates are for a shrinking global economy in 2023’s second half. We came into this year concerned about how consumers would withstand interest rate increases from global central banks including the U.S., Europe, the United Kingdom, Canada and other major economies still experiencing uncomfortable inflation trends. Higher interest rates mean higher borrowing costs for businesses, consumers and governments, potentially thwarting spending plans. U.S. consumers remain anchored by strong personal balance sheets and a still-robust labor market, with inflation-adjusted wage gains on a steady uptrend since June 2022 despite central banks remaining biased to tighten liquidity to stave off inflation.
In addition to higher interest rates as a concern for this year, liquidity measures — the amount of capital flowing through the economic system — presented another challenge for spending and corporate profits. Now that Congress suspended the domestic debt ceiling until after next year’s Presidential election, the Treasury Department is actively restocking its depleted coffers by issuing bonds, and that action takes capital out of the hands of private investors. Further, the banking system has avoided additional flare-ups at the individual bank level, which has provided some relative calm, although investors remain focused on sector-level issues like commercial real estate loans coming due and any deposit issues at individual firms.
We have upgraded our outlook on the path forward for diversified portfolios but retain a careful eye on several variables, including the labor market, central bank policy, an overly exuberant lift to certain sectors in the global equity market and liquidity trends as the year unfolds. Historical valuations for global stocks are registering close to longer-term averages despite very high interest rates competing for investor dollars. Commodities, the strongest outperforming macro asset class last year, have been the opposite this year, with some market observers suggesting their weakness points to foreboding economic activity. We would characterize our forward-looking views as skeptical participants seeking further confirmation that the durable trends reflected in global stock and riskier bonds are sustainable, and as always, we will keep you updated with our developing views.
― Eric Freedman, Chief Investment Officer, U.S. Bank
Global economy
Quick take: Aside from elevated inflation in most regions, global economic activity remains weaker in most countries. The slowing U.S. economy appears likely to narrowly avoid recession based on our U.S. Bank economics team’s viewpoints. Japan is a positive surprise, while growth remains slow in China and Europe.
U.S. equity market
Quick take: U.S. equities forged higher in 2023’s first half, with enthusiasm around artificial intelligence (AI) companies bolstering growth-oriented sector performance. However, market performance breadth remains narrow — not all sectors and companies are performing equally.
- The promise of AI is fueling speculation of a new technology super cycle, favorably impacting technology-related sectors and companies while driving broad market gains. Strong performance among the Information Technology (up 42.1%), Communication Services (35.6%) and Consumer Discretionary (32.3%) sectors helped the S&P 500 end the second quarter up 15.9% for the year so far. However, the remaining eight S&P 500 sectors ended the quarter up less than 10%, with five posting losses, which underscores defensive and dividend-paying stocks’ lagging performance.
- Persistent inflation, elevated interest rates and uncertainty regarding 2023 and 2024 earnings growth continue to stoke volatility while challenging recent equity price gain durability. Elevated inflation and associated higher interest rates erode earnings’ and dividends’ purchasing power.
- Companies are reporting robust but slowing consumer spending. Consumer spending, particularly on experiences, remains healthy, indicating consumer balance sheets remain in relatively good shape. However, an increasing number of companies are noting consumer spending has slowed. This elevates uncertainty and potential for increased volatility around the second quarter reporting release period, beginning in mid-July.
- Business customers, on balance, continue steady spending on productivity-enhancing technology. AI and data security-related spending remains solid as companies look to leverage the opportunities associated with accelerated computing, while also ensuring a robust cybersecurity infrastructure.
- The tug-of-war between bull and bear camps is balanced. A waning pace of inflation, increased likelihood that the Fed will soon pause its rate hiking campaign, mounting prospects for only modest economic slowing toward year-end, removal of the debt ceiling overhang, better earnings growth, AI-induced growth drivers and resilient consumer spending trends are among factors supporting a durable U.S. equity rally. Conversely, other factors indicate caution, including increased competition from bonds given higher interest rates, persistent inflation and a likely “higher-for-longer” Fed stance, and the potential for economic and corporate earnings pressures emerging later in the year. This balance of potential bull and bear outcomes implies continued macroeconomic uncertainty and increased price volatility, while supporting valuations remaining near historical averages versus at high and/or low extremes.
S&P 500 price/earnings ratio
Sources: U.S. Bank, Bloomberg, June 16, 2023.
International equity markets
Quick take: Warm weather and sufficient gas supplies helped Europe avoid a winter energy crisis, but persistent inflation, higher interest rates and structural headwinds temper our return outlook for foreign equities.
- Stabilizing earnings estimates and improved investor sentiment provide near-term support for foreign developed equity prices. Europe accumulated sufficient natural gas supplies for the region’s 2022-2023 winter season heating and industrial needs, while a historically warm winter led to lower heating demand. As a result, foreign companies’ 2023 corporate earnings estimates have stabilized, with analysts forecasting a 7% corporate profit growth rate relative to 2022, reflecting a modestly positive outlook. The trend in valuation, or the price investors are willing to pay for anticipated earnings, also evidences improved sentiment toward foreign developed equities as we conclude the first quarter.
- While some near-term concerns have receded, intermediate- and longer-term challenges remain. Elevated inflation continues to erode consumers’ purchasing power, while tightening monetary policy increases companies’ financing costs, impairing profitability potential. Europe and Japan continue to experience slowing or declining population growth, challenging longer-term growth prospects. Finally, secular growth sectors such as Technology, Communication Services and Consumer Discretionary represent a smaller mix in foreign equity markets relative to the United States. While we respect recent positive equity price performance, we continue to view the rally’s durability with some skepticism given ongoing intermediate- and longer-term concerns.
- China’s COVID policy reversal and Fed interest rate increases represent competing influences leading to two-sided potential outcomes for emerging market equities. Chinese authorities have quickly pivoted from restrictive “zero-COVID” policies and the economy recovered faster than expected in February. Elevated household bank deposits accumulated during the pandemic represent significant pent-up consumer demand for domestic and foreign goods and services. However, emerging market firms that need to raise capital are forced to compete with increasingly higher U.S. interest rates. A reopening China and tightening Fed monetary policy highlights two-sided outcomes for emerging market prospects, driving our balanced outlook.
Emerging markets country exposure
iShares Core MSCI Emerging Markets ETF
Source: Bloomberg, iShares, June 15, 2003.
Bond markets
Quick take: High-quality bonds offer compelling return opportunities with less sensitivity to business cycle risk. Decelerating inflation and a potential end to Fed interest rate hikes in coming months should act as tailwinds for high-quality bond prices. However, the risk that inflation may remain sticky and keep additional rate hikes on the table remains a threat to bond prices.
- Central banks expect to hold their target interest rates near peak levels to allow restrictive policy settings to work through the economy. The Fed rapidly tightened monetary policy with the intent of cooling inflation, raising rates from near 0% to more than 5% in just over a year. Treasury yields indicate investors expect the Fed will stop hiking rates in coming months. Meanwhile, the Fed continues to unwind its bond holdings and the U.S. Treasury is replenishing its general account with significant Treasury bill issuance, both of which weigh on liquidity. Private investors must step in to buy new Treasury issuance, which may reduce their investment in other assets and tighten financial conditions.
- Fair valuations on high-quality corporate and municipal bonds offer opportunities to generate incremental income over Treasuries. The extra yield paid by investment-grade bonds are near long-term averages, fairly compensating for credit risk if corporate and municipal bond issuer fundamentals remain strong. Higher borrowing costs are starting to drag on weaker issuers’ ability to cover interest payments, but high-quality issuers typically have lower debt burdens relative to earnings. Normal exposures to high-quality corporate and municipal bonds that are less sensitive to the economy’s fluctuations can help diversify portfolios while maintaining meaningful potential income from their improved yields. Incremental yield offered by high yield corporate and municipal bonds relative to Treasuries remain meaningful and compensate for credit risk, but if defaults trickle higher, dampening investor sentiment could hurt riskier bond prices.
- Mortgage bonds not backed by the government and insurance-linked bonds offer attractive income from unique return sources. Cautious investor sentiment toward a slowing housing market creates opportunities to earn high income with strong fundamental tailwinds in the mortgage bond market not backed by the government. Most home loans originated before 2022 remain well-secured by the value of the homes collateralizing them, even if home prices moderate, and homeowners have a strong incentive to stay current on their low fixed rate mortgages originated before borrowing costs rose. Investor sentiment and deteriorating liquidity remain the largest near-term risks. Reinsurance, also referred to as insurance-linked securities, continues to offer compelling yields.
Ten-year Treasury yield
Source: Bloomberg, June 15, 2003.
Real assets
Quick take: Income and earnings growth are above long-term averages for real estate and infrastructure assets. However, some specific assets in commercial real estate (CRE) face idiosyncratic risk. The primary risk facing capital markets remains the extent of the economic deceleration. Assets providing stable cash flows may provide solid performance should we see further deceleration in economic growth and inflation.
- Income continues to grow at an above-average pace for real estate companies, but that rate is slowing. Income growth should taper toward more average levels as we progress through the rest of 2023. Rising interest rates will negatively affect valuations across the real estate market. While private real estate is slowly adjusting to the shifting economic tides, publicly traded real estate investment trusts have already re-priced significantly and now trade at levels not seen since the coronavirus pandemic.
- Rising interest rates have led to underperformance of dividend-paying infrastructure assets in 2023. However, slowing economic growth and inflation in the year’s second half could lift infrastructure. Midstream energy should continue to produce outsized earnings growth even as the growth rate decelerates. We also expect the Utilities sector to continue producing strong and stable dividends and earnings growth.
- We view the backdrop for commodities as negative moving into the remainder of 2023. Decelerating economic growth will likely become more pronounced in the U.S. We believe the potential for a synchronized global slowdown will continue to pressure commodity prices lower, with precious metals an exception.
Alternative investments
Quick take: Hedge fund managers are positioning for opportunities amid macroeconomic uncertainty. Those who stay nimble and appropriately size the risks in their portfolios should perform well in this environment. Higher interest rates may improve tactical opportunities in fixed income.
- We expect many hedge funds managers to keep their overall market exposure low, but that stance does not mean they will avoid risk. Hedge fund managers’ risk appetite has generally increased this year as measured by leverage and overall net exposure to the markets (the difference between total long positions and total short positions). We anticipate managers will be more defensively positioned in the year’s second half, but additional market pullbacks may encourage some to reposition for upside volatility.
- Higher interest rates may improve investing long and short in credit due to spread widening (the additional yield investors demand for taking additional risk relative to safer Treasuries). Attractive opportunities may be emerging for managers focused on idiosyncratic debt due to a greater number of high yield bonds and leveraged loans trading at distressed levels.
- We view macro strategies intriguing in the current environment given their flexibility and breadth of asset classes in which they invest. Macro strategies have not performed especially well this year, but we continue to see opportunities for long-short investing among changing economic growth rates, interest rate levels and currency values.
Private markets
Quick take: Diverging venture capital and buyout strategy performance reflects diversity across private markets. Private market valuations currently reflect higher interest rates but positive fundamentals; if business fundamentals deteriorate, we see the potential for further downward pressure on prices.
- The outlook for unprofitable startups and for venture capital remains unclear. Higher interest rates and tightening lending standards have constrained funding and we expect further consolidation among startups. Based on our internal analysis, nearly 50% of the companies that listed on public exchanges in 2020 and 2021 are trading below the total value of investor capital raised by these companies.
- One positive factor is the breakthrough in artificial intelligence. Industry observers expect AI to add significant productivity gains to knowledge work, and investor sentiment could turn bullish in the near term on the promise of AI, leading to a recovery in valuations and providing renewed interest in emerging technology companies in the short to medium term.
- Private debt presents compelling opportunities despite headlines suggesting that defaults are expected to rise. Recently, bond rating companies Moody’s and Fitch cautioned that they expect the default rate on leveraged loans — debt issued to acquire a company — to rise. Our research leads us to a more nuanced outlook than a categorical rise in default rates across such loans. Direct lending involves investing in private debt funds that provide capital to private equity investors who, in turn, use the debt to acquire businesses. The debt issued in these situations is bilaterally negotiated between the interested parties and it is typically held by one to three private debt lenders. Debt levels are conservative, and this is usually the only form of debt on the balance sheet of the acquired company. The terms for this type of private debt are quite robust and provide for several avenues of recourse if the business runs into challenges. These combined factors favor investing in private debt opportunities with a seasoned manager for attractive risk-adjusted returns.
Rolling one-year internal rates of return
The internal rate of return is the annual rate of growth that an investment is expected to generate.
*2022 performance is through September 30, 2022.
Sources: U.S. Bank, PitchBook.
This commentary was prepared June 2023 and represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank in any way.
U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.
Diversification and asset allocation do not guarantee returns or protect against losses. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.
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