The C-Brief: An Updated 2023 Market Outlook

Two phrases seem to be on everyone's lips lately: resilience and “immaculate disinflation," the Federal Reserve's (Fed) apparent ability to slow the economy without job losses.

A stronger than anticipated GDP report for the second quarter – up 2.4% instead of the expected 1.8%, is a prime indicator of the resilience of the U.S. economy, despite lingering inflation and higher interest rates.

“Whether immaculate disinflation continues and what the Fed does next depends on how quickly inflation comes down and when, or whether, the much-anticipated recession hits," said Paul Single, managing director, senior economist and senior portfolio manager for City National Rochdale, City National Bank's investment advisory organization.

“Right now, the Fed is in a fine-tuning stage of monetary policy and will carefully watch data to see what impact their increases in the federal funds rate will have on economic activity and inflation."

In addition to reviewing the outlook for a mild recession and other domestic economic indicators, Single has insights into global economies, geopolitical risks, risks businesses face and the availability of capital.


Recession Risks: What Indicators Suggest

While some economists predict that the Fed will pull off a “soft landing" and manage to avoid a recession entirely, others have pushed back their recession timeline to the fourth quarter of 2023 or the first quarter of 2024. Rochdale's experts have a higher than consensus outlook for a mild recession later this year or early in 2024.

“The outlook for a recession has fallen lately because inflation pressures have come down sooner than expected, so the Fed may not need to be as aggressive," Single said. “At the same time, the economy continues to grow in part because of government spending, now that the infrastructure bill has kicked in and from the CHIPS bill that incentivizes building semiconductor manufacturing sites in the U.S."

Is the U.S. Economy as Strong as it Seems?

The economy has grown at 2.0% or better in each of the past four quarters, with business and government spending powering growth in the second quarter of 2023, Single said.

“While personal spending shows surprising resilience still, consumer spending is down in response to tighter credit, inflation and higher interest rates," Single said. “Consumption represented about half of the GDP gain in the second quarter; it was a lower contributor to growth compared to the average of the previous four quarters."

Consumer spending was up 1.6% in the second quarter, but down from the 4.2% increase in the first quarter of 2023. The manufacturing and housing sectors bore the brunt of higher interest rates and Fed tightening policies, but both appear to have stabilized recently, Single said.

“The economy is accelerating, inflation is falling, and unemployment is hovering around 70-year lows," Single said. “Still, there will be a point where the economy will slow due to rising business costs and higher consumer financing costs. The stage is being set for a slower pace of growth with businesses posting fewer job opening, consumers being more cautious with their spending, savings dwindling, credit card balances rising, less bank lending and job and wage growth slowing."


Is the Fed Defeating Inflation With Rate Hikes?

The Federal Reserve's decision to raise the federal funds rate in July, the 11th rate hike in the past 12 policy meetings, pushed the rate to its highest level – a median of 5.37% - in 22 years.

“The headline news is that the Fed is finished or close to being finished with rate increases," Single said. “The immediate demand for borrowing has slowed already, so the Fed will watch to see what happens."

There are several measures of inflation, with the consumer price index (CPI) the best known. Simply put, the CPI measures the price of goods in one period and compares it to past periods.

Data from the Bureau of Labor Statistics (BLS) shows that the CPI dropped dramatically from 9.1% in June 2022 to 3.0% in June 2023, primarily because of lower energy, food and medical costs.

“The Fed has little impact on those prices, which could just as easily rise again," Single said. “The Fed focuses on Core-PCE, which refers to the personal consumption expenditure price deflator. This index relates to how people spend their money on housing costs and services."

The Core-PCE excludes food and energy markets, two markets that are more likely to swing up and down regardless of economic conditions.

While Core-PCE inflation has declined year-over-year, it was minor – a drop of 0.8 percentage points from 5.4% in 2022 to 4.6% in 2023 – compared to the 6.1% drop in CPI, according to research from the Bureau of Economic Analysis (BEA).

“This is moving in the right direction, but it remains to be seen whether it will move down fast enough for the Fed," Single said. “But inflationary pressures are declining, the labor market is cooling and lending is trending downward, all indicators for reduced demand and smaller price increases. Those are all trends the Fed wants to see."


Strong Balance Sheets & Labor Markets

Between the strong labor market — with unemployment at a 70-year low — and strong household and corporate balance sheets, the U.S. economy is a much better position than it was in the 1970s, the last time the federal funds rate rose this much 16 months into the cycle, Single said.

“Households have significantly deleveraged and built up their savings during the pandemic because of lockdowns and stimulus checks," Single said, citing data from the BEA. “Personal savings grew by $2.4 trillion compared to 2019, but since the peak in August 2022, it's declined by $1.1 trillion because of paying down debt and subsidizing increased spending."

Consumer spending has shifted from goods to services as people continue to prioritize experiences as the pandemic impact fades, Single said. But consumer resilience will be tested by a cooling job market, slower wage growth, limited access to credit, rising delinquency rates and the depletion of excessive savings over the next two to four quarters.

While employment and wages tend to be a lagging indicator, the expectation is that the continued labor shortage, which BLS research shows to be about 3.8 million, will mute the impact of a recession on the job market, Single said.


Demand Keeps Housing Market Afloat

The Fed's increases in the federal funds rate over the past 16 months contributed to the rise in mortgage rates and the subsequent slowdown in the housing market, Single said.

“Housing construction as a part of GDP has fallen for nine consecutive quarters, so clearly not enough homes have been built," Single said. “Last year, housing costs were a major component of inflation, so the Fed slowed down demand with higher rates. Now, supply and demand are more in alignment."

The lack of existing housing supply is pushing up demand for new homes, which usually represents about 10% of the market, Single said.

“Mortgage rates are likely to stay high, but the demand for homes is still there," Single said. “There was a shock to the housing market in 2022 when rates shot up so quickly, but now people are adjusting."


The Outlook for the Rest of the 2023 U.S. Market

Rochdale's investment team has some doubts about the sustainability of the stock market rally.

“The S&P 500 rally has been driven by a handful of tech stocks," Single said.

Seven tech companies account for 28% of the total market value of the S&P 500. More sustainable bull markets usually have greater participation and outperformance from smaller companies, not just a handful of mega tech companies, Single said.

While recent stock market gains have been promising, Rochdale's investment team believes it's still too early to deploy risk, particularly because the market hasn't priced in fundamentals such as anticipated earnings disappointments. The expected slowdown in business and consumer spending is likely to have an impact on market returns.

Rochdale's investment team proactively decreased exposure to risk and has a mildly defensive position with reduced exposure to the riskiest equity asset classes, no international exposure and reduced exposure to cyclical industries. They remain focused on high quality U.S. stocks.

Portfolios have been reallocated to include investment grade and municipal bonds, with 54% in equities and 46% in fixed income.

The Global Outlook

Most of the developed countries in the world have an inflation problem similar to the U.S., Single said.

“The UK is worse off, which can be traced back to Brexit, because there are not enough workers and labor costs are high," Single said. “Europe is similar, facing higher energy and higher wage costs, but they're closer to ending their tightening cycle."

While China's economy was initially strong when it reopened after more than two years of Covid lockdown, the economy there is tapering off, Single said.

Geopolitical risks are extraordinarily high now, Single said.

“Unemployment in China is 25% for young people and the pace of their economic growth has slowed," Single said, citing data from the National Bureau of Statistics of China.

Capital Markets

Despite tighter credit conditions, the good news for businesses that want to grow and make investments is that there's capital available.

“There's tons of money out there in venture capital and private equity, and they're willing to invest," Single said.

While there's been a pullback in lending, bank portfolios remain strong.

“The fear of bank failures that dominated the news in the spring is pretty much a dead issue," Single said. “Investors aren't as worried and are returning to invest even in small banks."

Borrowers need more collateral and a higher down payment than in the past since lending standards are far more restrictive, especially for commercial lending, Single said.


Business Risks for 2023

While geopolitical unrest may impact businesses over the second two quarters of 2023 and into 2024, it doesn't pose an immediate risk, Single said.

“There's nothing catastrophic on our radar right now that we see as business risk," Single said.

However, business leaders must factor in the increased cost to borrow money, especially if they want to expand their businesses.

“The fear of recession is still there, but if we do have a recession, we expect it to be mild," Single said. “Usually, home values drop, unemployment spikes or people's investments are down as a recession nears. But that's not the case now."

The strength of corporate balance sheets should help businesses withstand a mild recession. Otherwise, like the Fed, business owners are in a watching and waiting period to see how the economy performs and how quickly inflation drops in the next few months.

The views expressed represent the opinions of City National Rochdale, LLC (CNR) which are subject to change and are not intended as a forecast or guarantee of future results. Stated information is provided for informational purposes only, and should not be perceived as personalized investment, financial, legal or tax advice or a recommendation for any security. It is derived from proprietary and non-proprietary sources which have not been independently verified for accuracy or completeness. While CNR believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and management's view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions which may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

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City National Rochdale, LLC, is a SEC-registered investment adviser and wholly owned subsidiary of City National Bank. Registration as an investment adviser does not imply any level of skill or expertise. City National Bank and City National Rochdale are subsidiaries of Royal Bank of Canada. City National Bank provides investment management services through its subadvisory relationship with City National Rochdale, LLC.