Tom Wald, CFA®, Chief Investment Officer, Transamerica Asset Management, Inc.
In this article we review:
Various market and economic factors that have changed since the year began
Recession risk that appears less severe based on recent economic data
Recent inflation data reflecting stubbornness within an overall declining trend
What now looks to be a more elongated higher-for-longer interest rate environment
How bond investors should be viewing the currently inverted yield curve
Opportunities within the equity and corporate bond markets
Two months into 2023 market factors have shifted somewhat, creating a changing environment versus where last year concluded. Against this backdrop we continue to believe opportunities remain over the year ahead within both the stock and bond markets yet feel investors should take the following points into consideration.
RECESSION RISK
Recession risk remains, however, the pending downturn appears to be less severe. While we continue to believe recession in the year ahead remains better than an even probability, recent strength in the economy, in our view, implies a future downturn is not likely to begin until at least 2H23 and is more apt to be moderate in nature as opposed to prolonged and severe. At this point we would equate the recession risk between now and year-end to be more akin to the downturns of 1990 and 2001, lasting less than a year and with peak-to-trough gross domestic product (GDP) declines in the 1% range as opposed to more dramatic contractions, such as those beginning in 1981 or 2007 lasting more than a year and with GDP declines in the 3%–5% range.
The macroeconomic debate has turned to one of less ominous outcomes. Given a shockingly strong January employment report (+517,000 jobs) accompanied by surprisingly favorable retail sales data (+3%) and the Atlanta Fed’s current 1Q GDP tracking estimate of 2.7%, the bull-bear economic argument seems to have moved from one of severe recession versus moderate recession to that of moderate recession versus no recession. While this change in perspective appears to have fallen into the short-term trap of “good economic news is bad market news,” we disagree and believe that less overall economic risk should prove more favorable for the equity and credit markets as the year moves forward.
Nonetheless, leading economic indicators still point to a high probability of recession beginning in the year ahead. At the current time, we assess the probability of a recession beginning in the year ahead to be approximately 60%, down from our previous estimate of 80% when the year began. We remain in the “recession more likely than not” camp as bright red warning signals are still flashing from both the Conference Board Leading Economic Index (LEI) and the slope of the Treasury bond yield curve. The Conference Board LEI, consisting of 10 economic, consumer, and market components with high historical correlations to forecasting downturns, has fallen by more than 5% over the past year. Throughout the past 40-plus years, this index has not declined by such an amount without the economy entering recession in the year to follow. In addition, the 3-month to 10-year Treasury yield curve recently reached an inversion of 1.26% in late January, its widest margin since the early 1980s and on a percentage-of-yield basis its largest ever. Since 1969, a recession has followed every 3-month to 10-year inverted yield curve within 18 months.
INFLATION
Recent inflation data displays short-term stubbornness within an overall downward trend. Inflation reports for the month of January came in hotter than expected with year-over-year headline and core (ex food and energy) consumer price index readings of 6.4% and 5.6%, respectively. While this was well below last year’s peak levels of 9.1% and 6.6%, it only represented a slight decline from December and a slower pace of moderation than consensus expectations. Moreover, the Federal Reserve’s preferred metric, personal consumption expenditures, actually experienced an uptick for the month with a headline reading of 5.4% and core inflation of 4.7%, yet also still below last year’s peak levels of 7% and 5.4%. We believe these reports serve to remind investors that declining rates of inflation are rarely linear and, like the markets themselves, will oscillate within a broader trend.
We continue to believe core rates of inflation stand a good chance to moderate during 2H23, however, monthly reports could continue to waver. As the cumulative impact of Fed rate hikes eventually result in weakening demand throughout the economy, we believe core rates of inflation should ultimately mitigate to 4% or lower during the second half of the year and this could prove to be a catalyst for the markets heading into 2024.
INTEREST RATES
Expectations have shifted to a higher-for-longer interest rate environment. Given the unexpected strength of economic data since the year began as well as the January inflation reports, we believe it is now more likely the Fed extends rate hikes into the summer months as opposed to a conclusion by midyear as we had previously anticipated. We now estimate the Fed continues 0.25% increases at upcoming March, May, and June meetings, taking the federal funds rate to 5.25%. The misguided market hopes of a pivot to rate cuts in 2H23, a notion we never ascribed to, now seems to no longer be part of the discussion. We also now see upward pressure on the 10-year Treasury yield to at least 4.25%.
We believe bond investors should heed the risk of the currently inverted yield curve and the potential future upward path of longer-term rates. History has shown yield curves typically invert prior to recessions and return to upward slopes as those downturns play out, which has proved to be the case in all eight recessions since 1969. Therefore, as the Fed continues to raise rates into an approaching recession, it is most likely the yield curve eventually reconciles to an upward slope via rising long-term rates, and for this reason we believe fixed income investors will be better positioned in short- and intermediate-term maturities.
CREDIT MARKETS:
We believe strong opportunities exist in short- and intermediate-term corporate bonds. High-yield bonds are now offering close to their highest levels of income since 2020 (ICE BofA US High Yield Index Effective Yield 8.5% February 27) and investment-grade bonds close to their highest yields since 2009 (ICE BofA Single-A US Corporate Index Effective Yield 5.4% February 27). We also view overall credit risk in the corporate markets as more benign than prior to previous recessions, in large part due to opportunistic refinancings during the pandemic and aggregate maturity schedules in the corporate markets more heavily weighted toward the latter parts of the decade.
EQUITIES
The next few months will likely be volatile for stocks, however, in our judgment, the equity markets could be well positioned for 2H23 and into next year. Opportunities for stocks are largely weighted on the concept that risks to the economy and corporate earnings are unlikely to prove as drastic as most have previously feared. While we do believe corporate earnings estimates for CY 2023 will continue to decline and likely turn negative versus CY 2022, this has been widely expected for some time and, in our view, played a major role in the precipitous price declines over the past year. Should we see S&P 500® net operating income for 2023 come in no worse than approximately 10% lower than 2022, that could actually prove to be favorable for stocks as the market begins to focus on 2024 profits. We would also cite the strong historical market returns in years following both peak rates of inflation and conclusions of Fed tightening cycles, the former of which we believe to now be in effect and the latter of which is likely to occur later this year. Therefore, while volatility will likely continue in the months ahead, we are maintaining our year-end 2023 S&P 500 price target of 4,400.
Clearly the early months of 2023 have included some twists and turns consistent with the volatility and market uncertainties that have created investor headaches for more than a year now. However, given the current yields on short and intermediate-term bonds and the longer-term opportunities for stocks as the inflationary and interest rate environments ultimately reconcile, we believe both credit oriented fixed income and equity investors have a lot more working for them than against them.
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Past performance does not guarantee future results. Indexes are unmanaged and an investor cannot invest directly in an index.
Equities are subject to market risk meaning that stock prices in general may decline over short or extended periods of time.
Fixed income investing is subject to credit rate risk, interest rate risk, and inflation risk. Credit risk is the risk that the issuer of a bond won’t meet their payments. Inflation risk is the risk that inflation could outpace a bond’s interest income. Interest rate risk is the risk that fluctuations in interest rates will affect the price of a bond. Investing in floating rate loans may be subject to greater volatility and increased risks.
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