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Our investment process is built upon a carefully constructed view of the economy and market trends, which we then square against what the market is pricing. Obviously “the market” is not a singular entity but rather an amalgamation of different investors in different regions and asset classes, and there are times when the market gives us a mixed bag of messages about expectations for the future. Today is one of those times, and we extract a different read depending on whether we are analyzing stock vs. bond valuations or sector price action. When we boil it all down, we continue to err on the side of caution, expecting the market and the economy to face a more challenging second half of the year than we experienced in the first half. This is despite the U.S. avoiding default after coming to the brink. As a result, we maintain an underweight to risk assets in client portfolios, waiting for a more opportune time to increase risk.

Waiting for Godot

If the U.S. economy does enter recession, as we expect to occur at the end of 2023 or early 2024, it will likely go down as the most anticipated contraction in history. The Fed began its aggressive rate hike campaign more than 14 months ago, tightening monetary policy at the fastest pace in decades. Yet the real economy has not shown signs of rolling over—with a few exceptions, particularly manufacturing. One interesting dichotomy in the economic data is the difference between the “soft” economic data—survey-based data sources like consumer confidence and purchasing manager indices that ask respondents to report on observations or expectations related to the economy—and the kind of “hard” data that show actual spending or investment by consumers and businesses. The soft data have been very disappointing, yet the hard data have shown to be much stronger than expectations. First-quarter GDP in the U.S. showed growth of 1.3% q/q annualized, and the Atlanta Fed’s real-time GDP estimate is projecting growth of 1.9% in the second quarter. Personal consumption expenditures were weak in February and March but bounced back in April. 

Should we believe the soft data or the hard data? Maybe both, if you can accept that the soft data are more forward-looking and the hard data either real-time or retrospective. It is clear that the Fed’s policy takes effect in the economy with a significant lag. This time, though, two factors are keeping consumers afloat longer than usual: 1) elevated savings from the extraordinary pandemic-era stimulus, and 2) a tight labor market due to early retirements and a drop-off in immigration during the pandemic. Our analysis shows that after adjusting for inflation, consumers still have excess savings of $3 trillion above the prepandemic trend. On a per capita basis, the highest amount of savings resides in the top 1% by income, but the rest of the income distribution is still sitting on savings that is 30%–42% higher than 2019 levels. Even companies are sitting on higher-than-normal cash levels, which could blunt the impact of tightening lending conditions. As long as the labor market stays healthy, consumers should continue to spend. In the first five months of the year, the labor market added an average 314,000 jobs per month. The latest Job Openings and Labor Turnover Survey (JOLTS) showed job openings back above 10 million, equivalent to roughly 1.8 job openings per unemployed person looking for work (in a typical labor market we would expect 0.5–1 job openings per unemployed). Weekly initial unemployment claims have ticked up this year, but continuing claims remain low, indicating that people losing their jobs are finding new ones quickly.

Of course, a healthy consumer flush with cash cuts both ways, and a higher propensity to spend could keep inflation above the Fed’s target if companies exploit pricing power. In fact, April inflation data disappointed to the upside, with core inflation especially proving sticky (either using the traditional ex-food-and-energy metric or the new focus of the Fed, the “supercore,” which looks at core services excluding housing), elevating uncertainty about the Fed’s path forward. 

Please see important disclosures at the end of the article.

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