2023 Q3 Outlook: Time to Think Again?

Having spoken with many clients as we approached the halfway point for 2023, the mood remains dire with respect to the investment and economic outlook. With interest rates having seen their fastest hiking cycle in our careers, talk of the impending recession and the next shoe to drop for the markets are pervasive. Bank failures, debt ceiling showdowns and the ongoing fog of war in Russia/Ukraine all contribute to a general sense of angst. So, perhaps it would be helpful to put some perspective around the conversation by assessing where we’ve come from, where we are now, and importantly, what might come next? Many have been calling for a recession for over a year now, yet it always seems to be “next quarter,” while in markets many talking heads continue to warn of the big correction coming to overvalued markets, etc. At the risk of letting the facts get in the way of a good bearish narrative, the reality today is that the economy has remained far more resilient than expected and many markets globally, led by the U.S. S&P500 and MSCI ACWI, are already in a new bull market (i.e., up over 20% from their recent lows)! Beyond the simple bearish narratives, maybe it is time to think again. Let’s take an objective look at what else might be playing out in markets, in the economy, and where we might expect to go from here.

Figure 1. Source: Morningstar Research Inc., as of June 30, 2023.

“It's tough to make predictions, especially about the future.” – Yogi Berra

But first, the caveat. As I have maintained for quite some time, we remain in a period of unusually elevated uncertainty because of the massive economic upheaval unleashed from the pandemic, economic lockdowns, extreme policy stimulus and ongoing Russian war. None of these are “usual” economic events and have severely distorted the normal cyclical economic patterns one typically expects to unfold. They have severely distorted much of the data and models used to collect, measure, and forecast both economic and market outcomes. To put it bluntly, our crystal balls are more broken than usual! There are no recent historical periods with which to compare our current situation. This elevated uncertainty is a challenge acknowledged by central bankers, such as Jay Powell at the Fed, and requires one to be more flexible and humbler in one’s forecasts and accept that there is a far wider uncertainty band around potential outcomes than usual. The same applies for investors: when uncertainty is elevated, your degree of confidence in your outlook is lower, and hence, portfolio positioning should reflect that higher risk.

Time to think again: Welcome to the new bull market

Globally, most equity markets peaked in late 2021 and fell precipitously in the first half of 2022 before bottoming out in October of last year. As of this May, markets had been grinding sideways for a year with the S&P500, for example, trading between roughly 3800-4200. We had anticipated that this sideways trend would continue. As written in our 2023 outlook, we expected that the October lows would prove to be the lows, but that the market would remain range bound into the back half of 2023, before rallying into year end. Instead, in June, the index on the back of artificial intelligence (AI) enthusiasm, broke through the top of its trading range and decisively into bull market territory of over 20% from the recent October low. Yet, instead of much rejoicing around the new bull market, most participants chose to downplay this fact. It is narrow and led by only a few stocks; the market is expensive; it is a bubble that will burst; etc. To which my advice is, look at the facts and perhaps think again. While it is entirely possible the rally will subside and we may see a resumption of the bear market, let’s at least be objective about the facts in making our assessments of what might come next, and be open to the very real possibility that we are at the start of the next bull market that may continue to unfold in a typical two steps forward, one step back manner.

Four observations:

First, it was not unexpected, it just showed up early. In my 2023 outlook, I suggested that we would remain stuck in a range till the second half of the year, by which I meant into the fall when markets often start looking forward into the next year. So, the current breakout does feel a bit premature by a few months. But markets are forward looking and if the market is ahead of my expectations by three to four months, well it wouldn’t be the first time!

Second, it is not narrow. Yes, the U.S. has been led by a handful of AI-related names, but many other markets, including the MSCI ACWI and EAFE indexes, are also in solid bull market territory, up 30% from their lows. This is a global phenomenon. Even in the U.S., the broader Russell 2000 has started to show signs of life over the past month. That many sectors and indexes such as the equal-weight S&P or the TSX are still moribund indicates to me that there is a lot of room for the bull market to march on through a broadening out of the recovery to lagging sectors, rather than just the AI gang of seven. In the U.S., the market in 2023 has been led by sectors and companies that were hammered in 2022. In other words, they are not the so-called “last men standing,” but rather new leadership from some of the companies most punished in the 2022 bear market.

Third, markets are generally not that expensive. While the headline S&P looks expensive at roughly 19x forward earnings, strip out the leading AI-related behemoths that trade in the 30s, and the rest of the market is closer to 15x with most sectors below their long-term average valuations. That a handful of mega cap-tech-related names in the U.S. are trading in a 30x range is not a huge concern. These are massively profitable and dominant franchises already and now positioned as key beneficiaries in the unfolding AI arms race. We can debate what might be fair versus overvalued but their current pedigree, cash flows and balance sheet strengths warrant a premium. Meanwhile, the rest of the world (Canada, Europe, Japan, emerging markets) is essentially trading around 13x, hardly stretched.

Fourth, AI names are not in a bubble (yet) and yes, AI is a big deal. I fully expect we will see a crazy AI-themed equity bubble to rival the crypto, weed and maybe even the dotcom bubble of the late 90s unfold in the coming years. We are not even remotely close today. When it unfolds, there will be countless “dreamer” application type names coming to market with zero earnings, maybe zero revenues, but huge dreams of total available market in the billions, etc. There will be initial public offerings and venture capital feeding frenzies, all the usual bubbly stuff to look forward to. That is not what is happening today – today, it is the leading tech platforms driving the rally (Microsoft, Google, Amazon, Apple, Nvidia, Meta, etc.). But these are some of the key suppliers required to build the upcoming AI infrastructure. Real companies, real cash flows, dominant market positions. As a group, they trade in the 30x range, not cheap, but far from crazy.

AI is the real deal. But it is also a generic term thrown around often with no clear definition. From my perspective, what AI means for investors today is the intersection of massive quantities of data, massive data storage capacity and the catalyst for the current excitement, massive computing capacity enabled by the application of graphic processing chips (Nvidia) that provide an exponential leap in data-crunching computing power. I like to think of it as a picture is worth a thousand words analogy. A GPU is like a thousand CPUs, not a remotely accurate ratio, but it captures the concept of how much more powerful the current configurations are, versus what has come before. AI is not a new development per se, but it is an exponential leap forward in computing capacity, and hence, potential applicability.

While much of the current hype will settle down, there is no doubt that AI capabilities are on the cusp of broad applicability into every aspect of business and society in which a computer is involved, i.e., everything! While the tech companies are the key arms suppliers, the range of beneficiaries will be broad, as AI is an enabling technology that will drive productivity through massive shifts in how businesses operate and what they can deliver. Pay attention to the AI story, do not dismiss it, but don’t get swept up in all the inevitable hyperbole that will accompany the ongoing evolution in the coming decade.

Time to think again: Recessions, inflation and monetary policy

Beyond the market dynamics, there are three key macro reasons or nuances that lean against a simple bearish narrative and support the case to think again and question that narrative. The key fundamental drivers to consider are:

1. The “Waiting for Godot” economic recession.
2. Inflation is falling and will continue to decline.
3. The Fed tightening cycle is in the endgame.

The next big move is down.

The “Waiting for Godot” recession

So, when will the recession begin? “Next quarter” has been the answer since this time last year, always “next quarter.” Well, at some point the recession call is not just early, it is wrong. For over a year now, calls of a recession have been bedeviled by an economy that has been far more resilient to interest rate hikes than expected. To be fair, our base case remains that we should see a mild recession in response to the aggressive tightening cycle of the past year, but we also recognise the need to rethink that outlook and question what else might be playing out.

In our Q2 outlook, we laid out the case for a rolling desynchronized recession that impacts different segments of the economy at different times. Many of the more cyclical and interest-rate-sensitive segments of the economy, such as housing and manufacturing, have already seen a significant correction and are now starting to stabilize and potentially recover. Yet, this unfolded against a backdrop of a resilient household sector and ongoing pent-up services demand. Even if we now see further slowdown in consumption and household demand, which are inherently less cyclical anyway, it in turn could be cushioned by the easing of the manufacturing and inventory correction that is now well advanced. It is these sequential sectoral slowdowns, rather than synchronous all together downturns, that give rise to the concept of the rolling recession. When different segments of the economy correct in a sequential rather than simultaneous fashion, the broad aggregate economy slows down and bumps along the bottom, rather than seeing an overall deep contraction. Time will tell how the economy ultimately unfolds but when the data continues to confound your views, it is time to think again, and be open to other possibilities.

Inflation rules them all

In our January 2023 Outlook, we wrote, “As in 2022, so it will be in 2023. Inflation will retain centre stage in determining outcomes – to some degree for the economy and most definitely for asset markets.” We went on to say, “the Cinderella best case setup would see inflationary data fall faster than expected … but the economic data remains more resilient than feared, despite still slowing. The evil stepsister outcome would be more persistent inflation and weaker economic data.” Halfway through the year, and the scorecard is leaning in favour of Cinderella. As mentioned above, the economy has continued to surprise to the upside, while still slowing, and inflation is now starting to surprise to the downside. From a high of over 9% last summer, headline consumer price index (CPI) in the U.S. dropped to 4.9% in April, 4.0% in May and now just 3% for June.

Headline CPI is just one of many possible inflation data points to consider but it does capture the broad message that is important for investors to understand. Overall, inflation is an incredibly complex and nuanced issue and these days we spend a lot of time studying inflation. So, while CPI captures the essence of our message, we are not relying on just one headline number to reach our conclusions. We have spent a lot of time digging into the weeds to try to best understand the inflationary and disinflationary drivers. Some inflation metrics are higher, some are, lower but the read across is unanimous on the direction in which inflation is headed: inflation is coming down, the decline may have been slower than desired, but that is changing. I expect overall inflation will continue to surprise to the downside, driven in part from the key housing components of CPI that will start to slow following the significant lag in how housing gets incorporated into CPI models. I expect that the current concerns regarding sticky inflation will in turn become transitory. Either way, inflation remains the key variable to watch in the second half of the year.

Monetary policy: Done! The next big move is down

The Fed is done! Whether they add one or maybe two 25bps hikes from here is not material. Policy rates went from 0% to 5% over the past year and a half. Now we are reaching the end point for hikes. The Fed paused in June and will likely raise rates by 25bps in July. For perspective, they commenced the rate hike cycle with a 25bps hike in March of 2022, accelerated the pace to 50bps and 75bps hikes per meeting, before commencing their deceleration to 50bps in December, 25bps in January and now skipping a meeting in June. While they may continue to tweak here and there depending on the data, the Fed is, for all intents and purposes, done. The next big move in rates will be down and the only question is when and from what terminal rate. Go to where the puck is going, not where it was or is.

We expect the hurdle to cut rates will remain high and will require definitive evidence that inflation is back on track for their 2% target, but markets will move in anticipation. This is why inflation is key. If inflation does continue to decelerate, as I expect, and is heading toward a 2% handle across a broad spectrum of inflation measures (CPI, Core, PCE, etc.), by year end, then markets will have already discounted the expectations of rate cuts even if central bankers continue to talk tough.

Figure 2. Source: Bloomberg Finance, L.P., as of June 30, 2023. Not seasonally adjusted.

Inflation decelerating toward or even below target, with a slow but still resilient economy (to be seen), would be the true Goldilocks outcome. But now, if the economy does slow more than expected, the Fed can and will cut rates sooner and faster than otherwise. A return to benign inflation prints restores monetary policy optionality, and with policy rates north of 5%, they have ample room to cut significantly, if need be. The Fed Put has been reloaded.