- After a strong first half, higher interest rates are likely to dampen U.S. consumer spending and temper inflation. The U.S. Bank Economic team expects U.S. economic conditions consistent with a soft-landing as the economy decelerates into early next year. Risks skew to the downside, with sticky inflation forcing Fed rate hikes, raising odds of a mild recession in 2024. The tight labor market, with 1.5 job openings per unemployed worker in July, is likely to ease in coming months, and the restart of student loan payments and tougher lending standards should decelerate economic activity. Disinflation is likely to gather steam in the U.S. but will likely not reach the Fed’s target rate until late next year, according to the U.S. Bank Economics team. Higher borrowing costs are also a risk to the economy, with consumer and business budgets accounting for higher interest costs and federal debt service costs now totaling 14% of federal spending as of July 2023.
- Inflation and central bank interest rate hikes are slowing in Europe, but Japan remains a bright spot. Wage growth is boosting inflation across Great Britain and continental Europe. However, the region has so far avoided recession, with a few exceptions at the country level. Purchasing manager surveys indicate slowing manufacturing and services, with Germany the primary economy in recession. Energy costs are a key risk to the region as we head into winter with no Russian supplies due to sanctions. Japan’s growth is a bright spot for the global economy, escaping a short recession early this year. The Bank of Japan maintained low interest rate polices welcoming some reflation in its economy after decades of deflation. The economy appears likely to sustain its modest pace of real economic growth into year-end.
- Weak global manufacturing is hurting most emerging market economies. China, the world’s second-largest economy, saw modest economic growth in the second quarter, despite ending coronavirus-related restrictions. Consumer activity remains low and concentrated in experiences such as travel. Government stimulus measures focus on slight interest rate cuts and encouraging lending. Growth is likely to remain modest into year-end without more significant stimulus measures. Other emerging market economies remain more dependent than China on global trade and economic activity. South Korea and Taiwan are cyclically oriented and are therefore very sensitive to global trade and manufacturing. Global manufacturing business surveys indicate slowing activity and weak new orders activities, though India remains a bright spot. Other major economies, such as Brazil, depend heavily on natural resources; slow global economic growth is dampening global natural resources demand.
Market News
Q4 2023 Investment Outlook: Markets face headwinds as higher interest rates slow the economy
October 2, 2023
At a glance
Diversified portfolios started 2023 strong, but the third quarter reflected concerns about the forward path. Consumer spending is resilient, thanks to a healthy domestic labor market, stimulus savings, ongoing business capital expenditures and pockets of global economic strength. Further, despite higher interest rates and compelling yields relative to recent history, investors continue to show enthusiasm for stocks despite a shallow recession in Germany and disappointing Chinese growth impulses.
Interest rates and inflationary pressures remain the dominant factors shaping the capital market landscape. The U.S. Federal Reserve (Fed) and other major central banks’ interest rate increases intend to thwart inflationary pressures that remain persistent and above central bank target levels. We imagine central banks acting as the personal trainer to their respective economies, continuously elevating the treadmill ramp height in the form of successive interest rate increases. As those ramps remain elevated or potentially move higher, the runner — the economy — will likely fatigue, and the extent of the runner’s slowdown may lead to more challenging conditions for diversified portfolios than what we have seen thus far in 2023.
We have emphasized a more balanced forward outlook for diversified portfolios, not wanting to get overly bearish due to still-strong consumer fundamentals but also respecting higher interest rates’ impact on the economic runner’s pace. Higher bond yields, which move in the opposite direction of bond prices, offer investors the chance to collect income as they await the consumer’s forward path. Our viewpoints that follow factor in global considerations across asset classes, but please do not hesitate to reach out to us with questions on topics we have not addressed that are important to you.
― Eric Freedman, Chief Investment Officer, U.S. Bank
Global economy
Quick take: The global economy continues to shrug off elevated inflation and rising interest rates, though economic growth is likely to moderate into year-end. Global inflation may also continue to moderate slowly, with some supply constraints a key risk.
U.S. job openings to unemployment ratio
Sources: U.S. Bank, Bloomberg. Data period: July 31, 2003-July 31, 2023. Bars indicate recessionary periods.
U.S. equity market
Quick take: The popular broad-based U.S. equity indices trended higher in the first three quarters of 2023, spurred by ongoing enthusiasm around artificial intelligence (AI) companies. Market performance breadth remains narrow, however — not all sectors and companies are performing equally.
- U.S. equities are navigating competing factors, balancing the tug-of-war between bull and bear camps. Recent data indicates inflation’s pace is waning. Better-than-forecasted earnings growth, ongoing artificial intelligence-induced growth drivers and resilient consumer spending support upward-trending equity prices. Conversely, persistent inflation, higher interest rates, potential for corporate earnings pressures emerging later in the fourth quarter and already-elevated valuations are among factors tempering our outlook.
- Consumers continue to spend on experiences and essentials, while spending on discretionary items has lagged. Continued spending on experiences following COVID-related restrictions are benefiting travel and entertainment companies. A pick-up in discretionary spending such as electronics, home furnishings and general merchandise would signal improving economic strength. Goods spending will be a key focal area for third quarter company reports.
- Fast is getting faster, and speed, scale and efficiencies do not occur without technology. AI remains salient, impacting how we live, work and play while helping bolster performance of related Information Technology companies. Through the third quarter, the seven largest companies by market capitalization in the S&P 500 are up between 32% and 198% year-to-date. Corporate spending on AI, cloud computing, software and data security remains solid as companies leverage growth and enhanced productivity opportunities associated with accelerated computing.
- Opportunities exist in all market environments. Traditionally defensive sectors such as Utilities, Healthcare and Consumer Staples can benefit investors with shorter time horizons (less than a year) or who have a lower tolerance for risk. We favor defensive-oriented companies as well as select companies in cyclically sensitive sectors such as Financials, Real Estate and Energy with dividend yields close to the S&P 500 but with higher dividend growth rates, which helps offset the effects of inflation. Longer-term, we regard opportunities within growth sectors such as Information Technology, Communication Services and Consumer Discretionary as compelling for investors with time horizons of a year or more and a greater tolerance for price volatility. While these growth-oriented sectors are outperforming in 2023, secular tailwinds behind AI, machine learning, cloud computing and anywhere, anytime connectivity should continue to support associated companies over the longer term.
S&P 500 price/earnings ratio
Sources: U.S. Bank, Bloomberg, September 6, 2023.
International equity markets
Quick take: Strong revenue and earnings growth provide ongoing price support for foreign developed equities; a strengthening dollar and persistent inflation temper the region’s forward risk and return prospects heading into the year’s final quarter.
- Positive fundamentals and broad participation have provided price support for the region in 2023. Analysts forecast foreign developed 2023 revenues and earnings, represented by the MSCI EAFE (Europe, Australasia, and Far East) Index, to increase by 6.6% and 8.0%, respectively, according to Bloomberg. Contrasting with narrow U.S. sector leadership, foreign developed performance gains have been broad based this year, with 10 out of 11 sectors posting positive returns.
- A strengthening dollar and persistent European inflation balance our forward outlook. Higher U.S. real interest rates attract global investors’ capital away from markets with relatively lower real rates. The currency in the country with the higher real interest rate tends to appreciate due to stronger demand relative to the lower rate country’s currency. Consequently, a strengthening dollar relative to Europe and Japan decreases a U.S. investors’ total return from foreign developed equity investments.
- Emerging market equities’ forward prospects hinge on global technology demand and China’s policy support. Emerging market equity performance measured by the MSCI Emerging Markets Index continues to lag domestic and foreign developed peers in 2023. Weak global trade and technology demand have weighed on exporting countries, while China’s stalling economy hurt its large consumer-oriented platform companies. China’s expansionary monetary policy stands out among global peers by providing additional liquidity this year while other central banks contract money supply. While analysts forecast a strong revenue and profits recovery across emerging markets in 2024, recovering global demand and China’s efforts to stimulate consumer spending remain keys to drive equity prices higher in the quarters ahead.
Global money supply growth (three-month change, annualized)
Sources: Bloomberg, U.S. Bank, July 31, 2018-July 31, 2023.
Bond markets
Quick take: Yields on high-quality bonds are near their highest levels in 15 years, creating competitive income generation versus riskier assets. Investors anticipate the Fed may hike interest rates once more this year before cutting rates by around 0.75% in 2024.
- Central banks expect to hold 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, lifting rates from near 0% to near 5.5% in just over a year. Investors anticipate major central banks will cut rates starting in 2024 as inflation ebbs. While Treasury yields should fall as inflation and economic growth cool, yields continue their trend higher (and bond prices lower). Higher Treasury issuance due to ongoing fiscal stimulus necessitates higher investor demand to keep bond yields stable. Higher inflation for longer could derail investors’ hopes for aggressive rate cuts in 2024 and translate to stable or higher Treasury yields.
- Reasonable 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 their credit risk. High-quality issuers typically have lower debt burdens that support their ability to meet obligations as the economy decelerates. 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. Potential tax benefits of certain municipal bonds make them particularly important for investors in high income tax brackets within accounts subject to taxation. Riskier high yield bonds offer less compensation compared to Treasury yields than historical averages, while credit fundamentals remain benign and defaults are low, despite rising somewhat this year. Increasing interest costs and tougher credit availability may begin to challenge weaker issuers the longer interest rates remain elevated. Normal, modest allocations to riskier bonds remain appropriate, but prices may be harmed if defaults trickle higher and investor sentiment falters.
- Mortgage bonds not backed by the government and insurance-linked bonds offer attractive income from unique return sources. Rising home values and amortizing mortgages result in loans that are well-secured by the value of their collateral, while homeowners have a strong incentive to remain current on payments tied mostly to inexpensive fixed rate loans. Reinsurance, also referred to as insurance-linked securities, continues to offer compelling yields.
Ten-year Treasury yield
Source: Bloomberg, September 11, 2023.
Real assets
Quick take: Inflation and interest rates present risks for real assets. Rising interest rates have taken a toll on cash-producing assets this year, even though fundamentals remain strong. There is potential for outsized gains as inflation ultimately slows toward the Federal Reserve’s target level.
- Public real estate investment trusts (REITs) trade at discounts to the asset value of the properties in the portfolios, providing a cushion to REIT prices if fundamentals deteriorate more than expectations. Aside from property types with distinctive risk factors, like offices and retail spaces, most properties are performing well — although income growth is slowing. Stronger secular growth areas of real estate, like data centers, benefit from technological infrastructure needs, such as artificial intelligence, supporting modest growth for the sector.
- Utilities and midstream energy should continue to generate above-average income growth. Those growth rates will slow but likely remain well above long-term averages. Additionally, both sectors should continue producing strong and stable dividends for income-oriented investors.
- Decelerating economic growth and inflation should slow commodity demand. Slower global manufacturing and trade activity should pressure broad commodity prices. Oil may be the exception; the extension of production cuts through year-end by Saudi Arabia and Russia, two key members of OPEC+, the Organization of Petroleum Exporting Countries and 10 allies, have constrained global oil inventories, lifting prices.
Bloomberg Commodity Index (BCOM)
Sources: Bloomberg, U.S. Bank.
Alternative investments
Quick take: The market backdrop continues to be positive for many hedge fund strategies. We saw managers make diverse decisions in midyear positioning amid myriad complex macroeconomic and geopolitical risks. This contrasts with the start of 2023 when bank failures and recession concerns led hedge fund managers to position defensively and remain agile.
- Hedge funds focused on equities are benefitting from performance dispersion at the sector level and stock prices moving significantly higher or lower. Managers identify investments to both buy long and sell short, and managers’ appetite for risk has generally increased this year. Market pullbacks may also encourage some managers to position portfolios for upside volatility. Hedge fund specialists in the Information Technology sector are among the best-performing strategies in 2023, benefiting from sector performance dispersion. Mean reversion strategies, which benefit from converging performance trends, are positioned well over the next few quarters if dispersion falls.
- Fixed income managers are finding ample trading opportunities amid a shift in attention by policymakers from inflation to growth, signaling interest rates may stay higher for longer. Higher interest rates may ultimately slow economic activity and improve long and short investing opportunities in credit markets due to widening yield spreads (higher yields compared to Treasuries) and a greater number of high yield bonds and leveraged loans trading at distressed levels.
- We continue to see opportunities for event-driven strategies. As we noted last quarter, we expected hedge fund managers to keep an eye on macroeconomic uncertainties but shift their focus to individual security selection. Event-driven strategies, including activism, target idiosyncratic situations and are performing well this year. Activist hedge fund managers seek to engage with company managements to unlock value in depressed stock prices.
Private markets
Quick take: The listing of three large privately held companies on the public stock exchanges — ARM Holdings, Instacart and Klaviyo — is a harbinger for additional initial public offering (IPO) activity in the months ahead. The success or failure of these companies to attract public market investors will determine whether other venture capital (VC)-backed companies will follow their lead. The listings are a litmus test for IPO markets that have been effectively frozen since the Fed embarked on interest rate hikes and have broader implications on the private market deal activity.
- High-growth companies are receiving renewed interest. The Renaissance IPO Index, which tracks price performance of recent public listings (companies that have listed on stock exchanges over the past three years), has risen by 31.5% year-to-date compared to 11.7% for the S&P 500 Index. Cava Group, a Mediterranean fast casual restaurant brand, launched a successful IPO in June with the stock rising by 115% on the first day it started trading on NYSE exchange. The company is profitable and reported 64% year-over-year revenue growth in the second quarter financial results.
- The number of VC-backed companies with delayed IPOs due to poor market conditions in 2022 has increased considerably. The success of the ARM Holdings, Instacart and Klaviyo public offerings could help release some of this backlog with IPO activity gaining steam in early 2024. However, public investors are now interested in profitable growth rather than growth at any cost, as was the case during the low interest rate regime of 2020 -2021.
- Our focus continues to be early-stage growth investing. As experienced private market investors across market cycles, we partner with managers targeting investments at a stage of a company’s growth cycle when the company’s valuations are anchored in business fundamentals. We avoid managers focused on the late stage, pre-IPO private funding rounds because valuations at that stage are speculative and tend to be inflated, boosted by non-traditional, cross-over investors such as hedge funds and mutual funds. We also focus specifically on profitable growth and avoid frothy market segments by seeking prudent investment partners.
The identification of named IPOs is for illustrative use only and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest and is not a representation or solicitation or an offer to sell/buy any security.
This commentary was prepared September 2023 and represents the opinion of U.S. Bank. 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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