A solid first-half rally sets up 2023’s second half as a tug of war between still optimistic market expectations for a soft landing and cautious economic forecasts calling for recession. The robust U.S. equities rally shines in contrast to muted gains across most other economically sensitive financial markets, including oil, copper and high-yield bonds.
We continue to believe a recession is the most likely outcome, given the many unfavorable leading economic indicators and the speed with which economic momentum can deteriorate.
Six months ago, many predicted the most anticipated recession ever in 2023. This was strengthened by three of the four largest bank failures in U.S. history. Yet equity markets have been unfazed by the regional banking crisis, rallying 15% since the mid-March collapse of Silicon Valley Bank. The S&P 500 Index is 9% above the average strategist forecast coming into the year and a stone’s throw from reclaiming its all-time highs.
The year’s midpoint is a natural time to reflect on how events have unfolded relative to expectations. Are we riding a bear market rally, or is a new durable bull market emerging?
The answer is muddied. The bottom-up consensus shows U.S. equities pricing a return to positive earnings per share (EPS) growth in the second half of 2023 with a sharp acceleration into year-end. By contrast, economists’ forecasts suggest gross domestic product (GDP) growth will continue to slow. Nominal GDP growth is expected to remain positive, but largely as a function of inflation, which is expected to cool further but remain well above the U.S. Federal Reserve’s 2% target through 2024. This conflict presents a dilemma for investors.
The case for a soft landing is buoyed by the housing sector, one of the most interest-rate sensitive areas of the economy. The economy can enter a recession while the housing market is healthy, as it did in 2001. In May 2023, housing starts had the largest monthly pickup in over three decades, while the S&P/Case-Shiller U.S. National Home Price Index bounced in its two most recent readings.
Because of this strength, the U.S. economy could experience a series of rolling recessions in particular sectors, owing partially to post-pandemic normalization impacting different areas at separate times. As strength in one sector offsets weakness in another, the overall economy might not enter recession.
The strong move in equity markets so far this year also supports the soft landing case. Markets are forward looking, but they are not always right.
Since World War II, markets experienced positive returns 42% of the time in the six months prior to a recession’s start; in the three months prior, they were positive 25% of the time. Returns in both periods typically were muted, with investors clinging to the bull case until the very end.
But positive price action, and the absence of a large equity market downturn, does not preclude slipping into recession. Questions remain concerning the durability of the current rally.
Retail and institutional investors are more heavily invested now than when this year began, making positioning less of a tailwind. Sentiment flipped from extremely negative to bullish. Valuations are elevated, just over 19 times forward earnings, implying an optimistic growth path ahead.
Different signals emanate from some of the most economically sensitive assets, often used to discern market-priced growth outlooks. These include oil, copper, small cap stocks, financial stocks and high yield bonds, which have not bounced back as much as after past major lows.
With pricing in other asset classes implying more caution, the S&P 500 Index may be the outlier.
The equity rally has been narrow, dominated by a handful of the largest names. The market cap-weighted S&P 500 is beating the equal-weighted version by 10%. If this holds through year end, it would be the largest gap since 1998. Investors should keep in mind that, after several years of narrow market leadership and pronounced mega cap outperformance, in the early 2000s those stocks experienced large price drops – and a broad shift in market leadership ensued.
These periods of mean reversion have proved fruitful for active managers, with their flexibility to avoid overvalued pockets and overly lofty embedded expectations and instead focus on neglected areas. Although market participation recently broadened, economic surprises could stall investor extensions into the more cyclical areas.
Whether a soft landing or a recession will emerge will take time to play out. Only then will we be able to determine who is right – cautious economists or optimistic equity investors.
Jeffrey Schulze, CFA, is Director, Head of Economic and Market Strategy at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice. Past performance is no guarantee of future returns. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.
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