Macro Outlook 2023
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Expect a recession, greater-than-expected Fed cuts, and a rebound in Tech in 2H of CY 2023
Our View
The second half of CY 2023 and the first half of 2024 will experience a much steeper drop in economic activity than currently expected. This is due to sustained weakness in new orders, tight credit conditions, and global malaise such as smaller pickup in credit by Chinese private businesses. This implies greater weakness in economic activity and in demand for commodities such as oil — any near-term bounce is likely to fade as cracks in the economy begin to accelerate by Summer of 2023.
In this environment, we prefer long-duration assets, like Nasdaq over S&P 500, and dislike commodities and cyclical sectors. We think the market may test the 3800 level on SPX in the second half of the year but will likely end the year higher. Although there are uncertainties in our forecast, the path of economic trajectory is becoming clearer.
The Context
Consensus estimates for US GDP have risen year-to-date on the back of a rebound in economic activity in Q1. While many street economists forecasted a recession in 2023, resilient jobs data (such as a still-low unemployment rate), a pickup in economic activity (such as Services PMI), and hotter inflation, pointed to an acceleration in growth in Q1. This acceleration drove interest rates higher, with market estimates of the Fed Funds terminal rate1 racing from around 4.6% at the beginning of the year to 5.6% by March 8, 2023.
Ultimately, this rise in interest rates caused the banking crisis (see: SVB), as losses in their bond portfolios exceeded (or came close to) their total equity.
Our view is that banking stress is a feature of an inverted yield curve and is a consequence of Fed policy. We believe that regional banks are still challenged and will remain so until yield curves steepen.
We also believe that stress in the banking system will reduce credit supply in the economy, speeding up a contraction in activity. The Federal Reserve’s Sr. Loan Officer Survey points to very tight credit standards — and this was in January.
Credit is a very important driver of growth in developed economies, and with the credit impulse already negative (as of end of December 2022), we expect it to weaken further.
As higher interest rates cool demand, the result is a decline in new orders for business and in backlogs of work.
We believe this current dynamic of declining business activity and higher interest rates is not sustainable — without a pickup in new orders, businesses will be forced to shed workers, resulting in higher unemployment rates. Labor markets are already cooling, and we expect acceleration by Summer 2023.
Where we are today
Aggregate sell side estimates point to a still positive GDP outlook for 2023, but we feel more comfortable on the left tail of distributions given the path of data and the banking stress.
While the market has moved to price in Fed Rate cuts in 2023, we believe that the current trajectory of the economy warrants deeper cuts than expected.
We see the Fed cutting interest rates by at least 100 bp in 2023, with up to 300bp of cuts by end of 2024.
Risks and Things to Watch
We are watching to see if consumer confidence can sustain spending and ultimately lead to a rebound in new orders.
Resilience in emerging markets, especially MENA & India, could spark demand for capital goods driven by the theme of manufacturing shifting from China to India and other South-east Asian countries.
China may increase the level of easing, injecting more credit into their economy — however, pickup in credit usage remains low, suggesting officials may rely on fiscal and financial sector policy.
Debt ceiling debacle may have a temporary negative effect on bond yields and market prices.
We expect data in the near-term to provide a mixed signal and may result in a Fed error at the end of Q2 when they release an updated Summary of Economic Projections — this is because we anticipate data to roll over around July, after the June FOMC meeting.
Cross Asset Strategy
We believe that equities will be mixed through the rest of the year, and see the S&P 500 trading between 3800 and 4300; we are more positive on Nasdaq and see technology stocks gaining steam through the rest of the year on the back of secular growth themes.
Commodity prices, such as oil, we expect will move lower as global demand continues to wane — the OPEC production cut of 1.3mbpd is likely just the first cut, but we don’t expect oil to truly bottom until Q3 2023.
Bond yields should continue to decline as the Fed responds to economic fallout around Summer 2023.
Muhammad Wahdy
Portfolio Manager
Wahdy Capital
Simplified: the markets expectation of the highest rate the Federal Reserve will set