Are We There Yet? Mid-Year Economic & Investment Outlook

Are we there yet? Will the recession ever arrive? In this video we share Capital Steward's investment and economic outlook for the second half of 2023. We discuss our views on inflation, the economy, the stock market and bonds. Most importantly, we share practical advice for you to consider moving forward.

Transcript:

Hi everyone and welcome to Capital Steward’s second half outlook for 2023. In this episode of the podcast and in this video, we're gonna dive into our expectations for. Markets and the economy and inflation, geopolitics, all those kinds of things. For the second half of this year, I titled this one.

Are we there yet? Because we're gonna talk a little bit about the recession. That never seems to quite arrive. Everyone's been expecting it to happen and we just haven't gotten there yet. In , our outlook for the full year, back in December of last year, we laid out some cases for a recession for this year.

And also a lot of reasons why we might not see that. And so we're gonna update some of those views and we'll share where we think markets and the economy are headed in the second half of the year.

The story of markets so far this year has been the bounce back of US stocks. Virtually no one on Wall Street or in the financial media, even those that didn't think we were gonna have a recession this year expected the s and p 500 to be up 14% in the first half of the year.

Gold has also done well. Bonds have been flattish and commodities like oil and, and food stocks have been down materially. Just like the first quarter. The second quarter has been a bit of a rollercoaster and the inability for the folks with all the king's, horses and all the king's men on Wall Street to predict what was gonna happen in the first half of this year further demonstrate demonstrates why it's so important to identify a long-term investment strategy that you can stick with regardless of what's happening in markets.

As always, since are long-term investors, we start by looking at long-term returns. We don't wanna get caught up in short-term thinking that could cloud our judgment and sort of miss the forest through the trees. So, Looking over the last 25 years, the s and p 500 is earning just under 8% on average.

Over time, I think during downturns or volatile times in the market, it's especially important to look at long-term returns and we can look at prior peak to trough declines versus today. So what I mean by that is if you hit in, invested in stocks, which are the red line, the s and p 500 on the page or bonds for that matter, which is the green line.

At the height of the tech bubble or right before the great financial crisis, or right before the Covid crash in 2020, you would still be a really happy investor today. So we're gonna talk about where the markets stand, where the economy stands. . And, and our views should never preclude you from buying and holding the right long-term investment portfolio.

You likely have long-term investment goals. And so no matter what anyone says about the economy where it's going or in markets where they're going, it's really important that you keep a long-term perspective so that you can participate in great returns over time.

If we zoom in just slightly to the last decade if you've been an investor, you still likely experienced significant stock market returns even after the 2022 downturn. Stock markets are well above their pre covid peaks.

Over the last decade,, stocks have been the best performing asset class followed by real estate, and that's even more true if you bought real estate with, with debt, with mortgage. And bonds have slightly underperformed inflation largely because of the spike in inflation we've seen over the past.

Over the past year. As long-term investors, s and p 500 returns have been nine to 12%, and that's generally more than enough to accomplish our goals. With interest rates now at highs that we haven't seen since the last decade, bond returns going forward should be higher than the two to 4% historical averages.

So even with perceived volatility in markets, it's more important than ever to build an investment plan that you can stick with so that you can take advantage of long-term compound returns. So if you're not comfortable with your current plan and you don't think you have something that you can stick with long-term, then you need to seek out professional guidance.

Our team would be happy to discuss your situation in depth. We'll put a link in the show notes to make it easy to get in touch with our team. Whether you're watching this video on YouTube online, on our website or in in the podcast form. So, okay, now that we've had a little bit of a backdrop on long-term investing and we understand where we sit vis-a-vis history, let's dive into our views on the current state of the economy and where we think markets are headed for the second half of the year.

Demand for workers is starting to flatten out, and then we have.dot dots.

The labor market remains very strong, especially in service sectors. We continue to see a gap of 4 million workers between the number of open jobs and those available to work. When we look at the employment to population ratio, which is the broadest measure of the percentage of people in the US that are working, and that takes away some of the noise you see in some of the labor force participation numbers, you see that the percentage of workers in the.

Employment to population ratio has been ticking up gradually, but we're still pretty far below pre covid levels, and we're even further below the levels that we saw at the turn of the century. So alignment between available workers and jobs is gonna have to come from somewhere and it's probably going to have to come from a combination of reduction in the number of available jobs.

And that happens by slowing down the economy, slowing down demand and also through increased immigration. Wage growth is still running at 5%, which is significantly above historical levels that needs to move lower for inflation to drop. There's some indications out there, some of the. More real time numbers that, that, that's starting to move in the right direction but still running high relative to history.

For those of you that are kind of following the story around ai, artificial intelligence it's likely the biggest economic implication of ai. AI is going to help us bring the labor market and our available workers back into balance. That's gonna take a while. But when you think about advanced analytics manufacturing and AI capabilities that's gonna help reduce the number of workers that are required to do jobs, to keep the economy going.

And that will help us balance out the labor force long term. That's gonna be a multi-year, probably a multi-decade story, so we have a lot of room to go there. So this is a part of inflation that even as we see inflation go down, and we're gonna talk about this more in a minute. This, this is going to be sticky.

It's gonna be the most sticky part as we, as we move forward.

So let's talk about another really significant part of inflation, and that is housing. Housing costs are the other major contributor outside of the workforce. To core inflation, which is the thing that you've been hearing about so much in the news. Housing contributes about 43% to core inflation stats every month.

Rent for renters out there is about 10%, and then that number of owner's equivalent rent, that's the other 33%. And remember, owner's equivalent rent is the calculation of the cost. To sort of rent for homeowners. It's a survey metric. So the rent relationship to home prices is not absolute, but home prices are the major factor in how they how they calculate that.

So you can see both rents and the change in home prices have come back to pre covid levels and they're moving lower. Remember year over year change is what we used to measure inflation. So that doesn't mean that rents and home prices have actually declined. Your house value probably has stayed right where it is, but they're simply increasing in a much slower rate, if at all.

And that slower rate of increase will work its way into C p I calculations or the consumer price index calculations over the next few quarters. And that means that our core consumer price index or inflation should continue to decline.

So what does that leave us with in terms of inflation? We've discussed for many quarters the need for fed policy rates to move above the core inflation number that we, that we measure to sufficiently slow the economy, and we're likely to see that finally occur sometime in the third quarter of this year.

You can see on the chart that core inflation has dropped from 6.6% down to 5.3%. Headline inflation has moved down even more as energy prices fell this year. And for what it's worth, the Fed's preferred inflation measure, which is the personal consumption expenditure index or the P C E that's moved down to four point.

Three, 6%. So now that's below. That fed policy rate that we talked about, which is right now is five to five and a quarter. So inflation's going to continue to fall house prices as those feed into the inflation number that's gonna drive that lower end of the second half of the year.

Even if wages remain pretty sticky. And we think inflation's gonna fall probably until it reaches three to three and a half percent. Once core inflation gets into that range though, the fed's really gonna have to reckon with its 2% target and decide how much and how important that target really is.

To them long term with ai, anything's possible. And I do think that you'll see changes to labor demand that bring those things back in, in to balance. And ultimately we can get back to 2% inflation. But AI's not gonna significantly change the labor force before 2025. And so if the Fed wants 2% inflation next year, they're going to have to continue to hike rates in order to get that.

My suspicion is that we won't see that. So now let's talk a little bit more about rates and the Fed in light of the data that we have on the labor market, housing and inflation.

We've been beating a dead horse on rates for the last 18 months, kind of pounding the table. That rates would go higher than expected and stay higher for a longer period of time than most folks thought. In July of last year, in a mid-year review the market and the Fed expected rates to peak in 2023.

At around 3.7 to 5%, obviously rates moved much higher than that. The Fed policy rate is now five to 5.25% and the market has finally priced in higher for somewhat longer, as you can see on the left side of the chart with rates remaining above 5% through the end of the year. At over the last couple of days, the, the market's priced even, even slightly higher rates in more like five, five and a half to 5.75.

So, I do think it's worth taking. The Fed, chaired Powell at his word. They missed inflation early, but they've been quite good at guiding markets and they have a strong desire not to surprise market participant participants. Investors didn't believe that they would raise rates and for those folks that didn't believe that they were approved wrong we think that those.

That don't believe he'll continue to raise rates, even if they do it slowly, are also wrong. Ultimately we think the Fed raises rates perhaps once, maybe twice more as they suggest in their projections. But then they stay put As inflation continues to fall as inflation falls, higher rates become increasingly more restrictive on the economy.

So it seems to me that five and a half to 5.75% is probably the peak of the cycle. Now will holding rates steady reduce inflation to 2% near term? We don't think so. And the market isn't, isn't expecting that holding policy rates in the mid fives is probably enough to get inflation into that mid 3% range.

And the Fed will have to decide if they're comfortable with that or they'll have to reckon with their 2% target. And if they're not comfortable with inflation in a 3% range, then they're gonna have to go even higher on their, on their Fed funds policy rate to get that labor market even more in balance to drive out that last percentage point increase in inflation.

And that's gonna cause significant unemployment to happen. And we think that might be where the Fed sort of finds its balance and its mandate, the dual mandate between inflation and full employment. And they just let the market sort of ride with slightly higher inflation long term. If that's the case then longer term interest rates probably need to adjust marginally higher from here in order for the yield curve to get, to get back into balance.

So let's talk about maybe the, the million dollar question. Are we in a recession? Is a recession coming? We've been waiting on a recession for a long time. We're on sort of the summer, you know, a lot of folks are on summer road trips. And you know, you've got kids in the back if you're like us, and they're asking whether or not we're there yet.

We're gonna, we're getting on an airplane tomorrow to, to go to California and I sort of expect that there's gonna be a lot of, are we there yet happening while we're flying. As we expected at the beginning of the year, the economy is slowing, but it's not in a recession. The i s m survey.

For manufacturing is very weak. It's at that levels typically correlated with recessions. But the service sector business survey indicates very modest growth, sort of remained in May with a reading slightly above 50%. It's notable that the economy needed to slow from overheated levels in 2021.

You can see the record in IM business Activity data on this slide. So it's possible that we're simply slowing from an overheating. Economy and we're not imminently going into a recession from a business perspective. So the idea that we're not following into a recession imminently is further supported by consumer spending data. The consumer has been resilient up to this point. But spending it is starting to decline on an inflation adjusted basis. Retail sales are up just 1.6% , year over year. And so nominal sales, they're trailing inflation significantly.

If you listen to corporate earnings calls, you'll hear that they're selling fewer units, they're doing it at higher prices, and so they're growing sales and revenue, but they're doing that through price increases, not by selling more stuff. Spitting his move from physical goods in stores during the pandemic back to services.

That's sort of, was expected right now, that everybody is back out and about and traveling and doing the things that you wanna do to live your life. So non-store consumer spending is growing at 6.5%. So that's keeping up with inflation. Our view is the consumer is hanging on kind of a cliff's edge.

They're barely keeping up with inflation, but they are keeping up nonetheless. We're gonna talk in a minute about consumer spending. It makes up the bulk of the economy, so it's difficult for us to have a recession if we don't have more reduction in consumer spending. Consumer borrowing levels have risen but they've only risen back to pre pandemic levels.

So there's been big increases, but we're moving back to normal again out of the pandemic. There's no reason for us to believe that the levels of consumer borrowing that we see currently aren't sustainable long term. We sustained them for a decade going into the pandemic. Consumers saved an extra 2.1 trillion during the pandemic.

That is a lot of money. And about half of that had been spent down by the first quarter of this year. During the second quarter, the Federal Reserve Bank of San Francisco published a paper on excess consumer savings, and their projection showed that there's enough excess savings to support consumer spending into the fourth quarter of this year.

So it seems unlikely that the consumer's about to fall off the proverbial cliff anytime soon, especially with the unemployment picture remaining as it is with the number of open jobs that are out there in, in the economy.

So let's talk a little bit about GDP and, and where that comes from. So by definition, we are not in a recession. So you wouldn't probably know it from talking to your friends. It looks like GDP is gonna grow between one and 2% again in the, in the coming quarter. Consumer sentiment about the economy is very negative.

That's largely due to the inflation that everybody has experienced over the past year. But. Like we just discussed on the last page, consumer spending continues to grow, as you can see in this chart. Which shows the different components of G D P consumption. I e spending. It's more than two thirds of the United States, g d P.

And so if we don't get a significant decline in spending on services, it's really difficult for us to have a real recession. We can have a slowing economy, we can have slowing growth but you're not gonna get a recession without a decline in consumer spending. We discussed a lot of this in our 2023 outlook and, and.

A resilient consumer or consumer spending that continued to grow even at slow levels was one of the key reasons why we may not see a recession this year. And, and consumer resilience has been the reason why we haven't seen a recession to date so far in 2023. So our view is that the economy continues to slow because The Fed's increased interest rates are gonna continue to weigh on growth.

Again, that's the intention. That's not a bug of the policy, that's a feature of it. But we're not going into a recession imminently. If we do have a recession, it's at least another quarter away. So we have not arrived at the destination yet.

So let's, let's talk a little bit about banks and bank losses and kind of update that scenario from what was happening in in March. So in our second quarter update. We shared four reasons why we didn't expect the Silicon Valley Bank or S v B Bank. We didn't expect that bank run to turn into a systematic banking crisis.

You can see from the chart on the left, unrealized losses at banks likely peaked earlier this year. As rates have stabilized and slightly come down the unrealized loss book for the industry. Has also dropped. That doesn't mean that everything is all good. As banks, especially community and regional banks will struggle for several more quarters under the weight of their prior securities portfolios.

As those loans mature, they can be reinvested at higher rates, but until then, they're kind of stuck with loans and securities that pay less than prevailing interest rates. So you can see the significant decline in bank stock prices in the chart on the right regionals are down 26% since their 2022 peak.

And banks as a whole are underperforming the market significantly. So given this, I think the rate environment and the associated liquidity drain is largely priced into the bank stocks and I don't see a significant crisis unfolding from here.

So given where we sit with inflation and the slow growth rate in the economy, let's talk a little bit about what we think that means for the stock market. Last quarter we talked about the s and p 500, which is how we think about us large cap stocks being overvalued at 4,200.

Yet the market continues to move higher. The move has been mostly multiple expansion, which is fancy finance speak for paying more for the same thing. Really, in this case, it's actually paying more for less because as we expected, earnings fell in the first quarter and the consensus expects for them to fall again in the second quarter. So we've got companies producing less earnings and we're paying more for the stocks.

The equal weighted s and p 500 index is more representative of how each of the 500 companies are doing on their own. That's up just 5.3% for the year, yet the market weight index, which is what we talk about most frequently in the news and what we're doing analysis that is up 14%. And that's largely been driven by some of the top tech technology growth names that you hear about.

So, apple, Nvidia, alphabet, Google meta, which is Facebook, and even stodgy Microsoft. While the economy as a whole may be slowing apple continues to sell devices and sales are expected to grow more than 5%. Companies continue to shift into the cloud with Microsoft. Not to mention Microsoft own chat, G P T and Nvidia has a huge backlog of AI chips to produce. So a merely slowing economy isn't likely to cause any of these firms earnings to decline. They trade at lofty valuations, which is to say their stock price relative to their expected earnings is high. And interest rates would need to rise for multiples to fall.

And if we're right about inflation continuing to come down in the second half of the year, there isn't much of a case for a major move. Hiring rates 2 25 basis point hikes from the Fed isn't gonna cause Nvidia to sell fewer AI chips. So if the economy does slow and I, I expect that to happen. I continue to believe that more traditional value names like car companies or retailers are gonna suffer more than the tech growth space.

In the old world, we saw growth as discretionary, right? In today's world, I think the sort of more operative question is, would you cancel your iPhone or some of your Apple subscriptions? If we got a negative 1% GDP print, that's not very likely. So that doesn't mean that you buy the NASDAQ 100 and hold it for forever.

If we get a soft landing or if our view is right that the economy continues to slow but we don't have an actual recession . Then value stocks may have room to catch up to the tech stocks first half rally. So we think a more balanced approach between growth and value is prudent.

As we, as we move into the second half, the multiple or the price paid for earnings of companies in the stock market is the best predictor of long-term results. When stocks are cheaper, future returns are high. When they're expensive, future returns tend to be low. You can see in the chart the tight grouping around the trend line for long-term 10 year returns which illustrates the high degree of correlation between future returns and valuation ratios.

A current valuation level suggests a poultry 2.8% long-term return for the s and p 500. It's worth noting that this analysis applies to 10 year returns. Short-term returns, like what's gonna happen in the next quarter or the next, the next year are far less predictable. So that goes back to why we always start these conversations, but those long-term Long-term earnings chart and long-term growth charts.

Going back to growth versus value, the, the eight largest companies in the s and p 500 are trading at 31 times next year's profits. That's really expensive. The rest of the index is trading at 16 times next year's earnings which is closer to average. So again, this, this supports the case for investing where multiples are better right now, that's the more value oriented areas of the stock market.

Last point on US stocks. The market, both stocks and bonds is pricing in that soft landing at this point. So the market is expecting that that we are not gonna see a recession, that rates are gonna come down and that all things are gonna be good. So I wouldn't expect a major move higher from here just because that turns out to be the case.

We need to see higher earnings which lead to better valuations for markets to grind higher.

Turning to bonds long-term bonds outperformed in the first half on the chart. This is represented by the iShares 10 year plus US Bond E etf which generated 5.1 percent return versus the aggregate bond etf, which is our kind of broader market benchmark at 2.26% short-term bonds lagged at 1.27%.

For some of you, this may be surprising because short term funds have been marketed with 30 day yields, north of 4%. And that's true. The securities in the portfolio are currently yielding north of 4%, but that doesn't take into account the volatility of interest rates that impact your total return, that goes to your bottom line.

And so the danger of owning too much cash or short-term fixed income now as rates are nearing their peak. Is that they underperform both the broader bond market and your expectations for those sort of lofty risk-free yields. We started adding duration to portfolios. That means buying longer term bonds in the first half to get back to neutral after being focused really on the short term side of the market in 2022.

I would expect that approach to continue as we get into the second half of the year. And we truly hit that sort of peak in the fed rate hike cycle. Yields may move up modestly from here. But again, as we near the peak in rates, the sort of extra return, the extra yield that we get on longer term bonds more than makes up for the smaller increases in interest rates.

Let's talk a little bit about international markets. In our 2023 outlook, we discussed emerging markets and international stocks at length. The predicate to that discussion was the US economy was slowing, potentially going into a recession, and that made emerging markets in international stocks sort of a place to hide out relative to the us. Emerging markets continue to, to grow even China to even despite the popular press will likely grow faster than the US this year.

However, emerging market stocks now trade more in line with their long-term valuations. They're not as good of a bargain as they were earlier this year. They're still lower than US valuations but that takes into account geopolitical risks and other risks that come from investing in those countries.

So it's not likely that they're gonna rally and have valuations that are on par with US Stock Market. Europe is still trading at reasonable valuations, but. Europe is likely headed into a recession if they're not in one already. And so when we combine valuation and the economic outlook the US seems to be a better place to invest.

Now as the macro environment seems to be more resilient and, and when we think about investing long term, the US is, is the most attractive market over time. The only time not to be focused on the US is when we think the US is is going to have problems relative to the rest of the world. And as it, as the economy seems more and more resilient, And less likely to have significant problems than that makes us markets even more attractive relative to other places around the globe.

So,

So what should we actually do as investors given everything that we talked about? At the beginning of the year, we implored investors to begin allocating cash back into stocks. That turned out to be really wise advice. So we would advise you to continue to build your stock exposure. If you're underweight, there is a lot of cash that's sloshing around out there.

So a lot of investors still have a lot of cash. So even given the equity market rally, again, you're going back to long-term goals and long-term returns. If you're underweight, you need to continue to buy stocks throughout the second half of the year when there's opportunities to do that. Don't try to pick the top of the interest rate market or sort of the bottom of the stock market.

Again, maybe we've seen the bottom of the stock market, maybe we haven't. Hopefully returns, you know, we're getting close to the top of the the fed rate policy cycle here. But it's possible that, that we're not, and so it makes sense to, to allocate money over time. Cause it's really difficult to predict the day at which we're gonna hit either of those peaks.

And, and the third thing that I think is important, this kind of goes to, to number one, but be wary of holding too much cash. At high advertised rates, you may have disappointing long-term total returns. Just because you think the yield might be high, you may actually get something less than that in your portfolio.

So it's really important that you're really careful about the cash investments that you're making now that markets are functioning more normally. We do each of these activities on behalf of our clients every day. So if you're unsure of how to proceed it's super easy to schedule a call with us to get real professional guidance.

There's a link in the video notes. There's no sales pitch. We promise we won't even let you sign up to work with us if you ask. That'd be weird cuz we just met you. In an intro call, we just ask questions. We want to get to know you, understand your situation, and then if we feel like there's a fit, then we will reconvene with a formal proposal and talk about how we can address your unique situation.

A few reasons why. Our clients love working with us. We believe in being good stewards of capital. And that means kind of four things. We think you should be in control of your money, not be controlled by it. If you're worried about it, you're not in control of it, right? So you should tell your money where to go.

We think quality financial advice should be easy to consume. Should be able to watch videos like this should be able to get the guidance and the things that you need through simple digital tools. Not complicated ones, but simple digital tools that make it easier for you to spend time doing the stuff that you're really passionate about, like hanging out with other people, building relationships, working your community, not managing your money.

And we think that advice should come from fiduciaries that are solely concerned with your interest, not from people that are compensated to sell you stuff. Whether that's expensive mutual funds or insurance. If you're working with somebody who's a broker their job is to sell you things. At the end of the day, they have to sell you something to make money.

And so we think advice should come from people that are not trying to sell you things. And then lastly, we think our clients should be in the driver's seat. We want you to understand how your portfolio. And all the other financial tools that you have are helping you to achieve your goals so that you can make really smart decisions, be in control of your money steward money well for your goals and, and for the next generation and for the community around you.

If you're looking for help with investments or with multi-generational planning, we'd be happy to help you achieve your goals. And with that, we wish everybody. A great second half to 2023, and we will be back with more updates for the fourth quarter. And of course we'll be on the podcast channel and talk about other things in the weeks between now and then.

Look forward to seeing everybody soon!

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