Key takeaways

  • In the first half of 2023, stocks regained ground given up during 2022’s bear market.

  • Encouraging economic signals appear to be boosting some S&P 500 sectors.

  • While resilient so far this year, the economy is slowing, leaving investors to wonder if the current bull market is sustainable.

With the large-cap S&P 500 Index up 16.89%1 in the first half of 2023, stocks are clawing back losses amassed during last year’s bear market. Even more impressive is the technology-heavy NASDAQ Composite Index, up 31.73%.2 This year’s strong start stands in stark contrast to 2022’s bear market (representing a drop in value of more than 20%).

Last year’s broad-based downturn, affecting both the stock and bond markets, resulted in negative portfolio returns even for investors with well-diversified portfolios. The previous year’s market’s tumult appeared to be in large part a reaction to a substantive policy shift by the Federal Reserve (Fed). The Fed rapidly raised short-term interest rates and began, for the first time since 2019, reducing its bond holdings. Many feared that in its quest to lower inflation, the Fed’s actions could tip the economy into a recession.

So far, the U.S. has managed to avoid a recession. “The economy today can best be described as resilient,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. “The markets anticipated the economy would weaken more quickly in 2023, but that hasn’t been the case.” Freedman attributes the economy’s ongoing modest expansion to persistent consumer activity. “Consumers have been spending more than most thought they would to start the year, and that has led to higher corporate profits.” Investors appeared to respond to this news, helping drive stock prices higher.


Positive economic signals

The recession anticipated by many did not materialize in the first half of 2023. The economy slowed considerably in 2022, with the primary measure of economic activity, Gross Domestic Product (GDP), growing by just 2.1%. This was considerably lower than 2021’s impressive growth rate of 5.9%. In the first quarter of 2023, the economy maintained a similar pace to 2022, growing at a 2.0% annualized rate.3 Investors and economists anticipated a slowdown given the Fed’s determined effort to temper rising inflation by slowing the economy. “The economy’s held up reasonably well to this point because of the strong labor market (unemployment below 4%), and consumers' fairly strong financial position,” says Freedman. “Our U.S. Bank economics teams believes these factors will allow us to avoid a recession.”

“We’ve seen very narrow leadership from technology, communication services and consumer discretionary stocks. Those three categories generated double-digit gains through the first half of the year, with much of the rest of the S&P 500 lagging behind.”

Eric Freedman, chief investment officer for U.S. Bank Wealth Management

The Fed has made significant progress in its effort to lower inflation and achieve its target rate of a 2% annualized cost-of-living change. After peaking at a rate of 9.1% in June 2022 (based on the Consumer Price Index, or CPI, measured over the previous 12-month period), inflation has since retreated. The CPI for the 12-month period ending in June 2023 stood at 3.0%, its lowest level since March 2021.4 To combat inflation, the Fed has raised its target federal funds rate from near 0% to 5.00% - 5.25%. Additional rate hikes are expected this year.


Assessing recession risks

While the Fed hopes to avoid a recession even as it maintains higher interest rates, tempering inflation’s rapid rise remains its primary concern. As a result, the fed funds target rate is likely to stay elevated for some time.

Higher interest rates mean higher borrowing costs for consumers and businesses. That may dissuade some from adding debt to their balance sheets or make it more expensive for those who choose to borrow, particularly compared to conditions that existed prior to 2022. “If you envision that consumers are on a treadmill, it was set at a lower resistance level up until early 2022, and spending remained strong,” says Freedman. “Now, higher borrowing costs and reduced savings act as a higher resistance level for consumer activity. The steeper the ramp for consumers, the more likely that slower spending results.” Yet Freedman notes that through 2023’s first half, consumers have maintained sufficient spending levels to keep the economy on track. “People are spending more money on experiences such as travel and entertainment, with less money spent on furniture and other goods that they stocked up on during the pandemic.” Freedman says the spending trend on “experiences” reflects pent-up demand to pursue activities that were off limits due to COVID-related restrictions in 2020 and 2021.

Freedman says businesses are trying to make their own spending plans based on consumer spending projections. “Are companies looking to beef up operations? Are leisure and hospitality firms planning to expand their physical presence because they think more people will come to visit?” Freedman suggests these specific developments are important. “If you have large companies willing to expand because they think increased consumer spending is more realistic, that could be a telling sign that the economy will weather today’s challenges, reducing the recession risk.”

Freedman also notes the interdependent relationship between consumers and businesses. “Businesses are confronting higher costs, particularly for wages and borrowing. That can have a cascading effect on business expenditures. If business spending slows, that can ultimately impact consumer spending, and the interdependence persists.”

The extent to which consumers and businesses maintain current spending levels may also impact inflation’s path in 2023. “Labor costs are a critical consideration,” says Freedman. “Job openings exceed available workers, which can push elevated wage gains even higher.” That could partially offset the Fed’s inflation-reduction strategy. Factors such as wage gains merit scrutiny in the Fed’s ongoing interest rate strategy.

While the U.S. Bank economics team believes a recession will be narrowly avoided, Freedman says “if one occurs, our expectation is that it will be shallow. The bigger question is how long a recession endures if it occurs.”


Equities are increasingly earnings-dependent

With the Fed appearing close to their peak interest rate in the current cycle, equity investors are likely to place increasing focus on fundamental factors, specifically corporate earnings (profits). “Over time, earnings are what really drive stock prices,” says Freedman. “Corporate earnings announcements may take on greater visibility.”

Stocks have regained considerable ground after reaching a bear market low in October 2022. Following a brief rally in late 2022, S&P 500 stocks were largely rangebound between 3800 and 4200 during the opening months of 2023, but equities broke through 4200 in late May and continue to trend higher. And while the S&P 500 is up about 17% this year, it should be noted stocks are still more than 7% below market highs reached at the start of 2022.

Source: Chart depicts daily changing values of the Standard & Poor’s 500 Index, an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results.

Freedman notes that three industry sectors drove the U.S. stock market’s positive results in early 2023. “We’ve seen very narrow leadership from technology, communication services and consumer discretionary stocks.” Those three categories generated gains exceeding 30% through the first six months of the year, with the rest of the S&P 500 lagging far behind. Broader participation among other sectors is required to sustain an upward trend for stocks, Freedman says. “When leadership is narrow, it’s less healthy than a more balanced type of rally.”

As for bonds, many parts of the fixed income market are consistently trading in a narrow range. Yields on the benchmark 10-year U.S. Treasury note have varied from 3.30% to 4.25% since October 2022. “It is likely that bonds will remain in a similar range for a period of time,” says Freedman.

chart depicts yields paid on 10-year Treasury Notes from October 1, 2022 thru July 12, 2023.

Source: U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates.


What to invest in now

Freedman says that even with the encouraging economic signals so far in 2023, uncertainty persists and that could result in possible additional asset repricing. If consumers and businesses cut back on spending, it would likely result in reduced corporate profit growth, and consequently, lower stock prices. Freedman says the likelihood of this scenario playing out is not clear but deserves investor consideration.

“It’s critical, first of all, to have a financial plan that’s tied to the specific goals you hope to achieve,” says Freedman. “Next, be prepared to take what the capital markets offer given the current environment’s realities.” Freedman cites dividend-paying stocks, corporate and municipal bonds and parts of the real estate market not tied to the more challenged subsectors of office and retail properties.

More important, says Freedman, is to review your financial plan with your wealth services professional. If you don’t have a plan, take the time to establish one. Determine whether there are opportunities to rebalance your portfolio in ways that more appropriately reflect your investment objectives, time horizon, risk appetite and the current market environment.

Have questions about the economy, markets or your finances? Your U.S. Bank Wealth Management team is here to help.

Note: The Standard & Poor’s 500 Index (S&P 500) consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The S&P 500 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results.

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  1. Source: S&P Dow Jones Indices LLC, performance as of June 30, 2023.

  2. Source: NASDAQ Index Services Team, performance as of June 30, 2023.

  3. Source: U.S. Bureau of Economic Analysis, Gross Domestic Product.

  4. Source: US. Bureau of Labor Statistics.

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