Macro Outlook 2023 - 2H Update
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Macro Outlook 2023 - 2H Update
Also: FOMC Review
We continue to expect a recession, greater-than-expected Fed cuts, and a continued rebound of Tech through 2H of 2023.
We continue to project a steep decline in economic activity by the end of 2023 and through early 2024, as higher real interest rates intersect with still-weak new orders in manufacturing, tighter credit conditions, and a deteriorating global economic environment. While hard economic data (GDP, NFP, Employment Report, etc.) continue to show resilience, we are seeing cracks in the data, and expect further deterioration through the 2H of 2023.
In this environment, we continue to like long-duration assets, like Nasdaq over S&P 500, and dislike commodities, cyclicals, and interest-rate sensitive sectors. As economic risks pick up, however, we believe a greater allocation to cash and short-duration may be warranted.
FOMC Recap
The Federal Reserve raised interest rates on Wednesday to 5.25 - 5.50%, up 25 basis points as widely expected. Through the press release, and subsequent press conference with Fed Chair Jay Powell, we see view the move as incrementally dovish and think it is likely that this is the last rate hike of the cycle.
Key Takeaways
(1) The Fed cited tighter credit conditions as a weight on economic activity, hiring, and inflation. The FOMC saw a preview of Monday’s (7/31) Sr Loan Officer Survey and it sounds like the data will point to further tightening in credit conditions. The current data, last updated in April, pointed to the weakest credit demand since the Great Financial Crisis.
(2) During the press conference, Jay Powell said that Fed staff economists are no longer expecting a recession. This is an important change of opinion, as Fed staffers are considered to be more skilled forecasters and, for the past year, had seen a recession in contrast to the FOMCs “soft landing” scenario. This change in view has important implications as it means GDP estimate revisions are likely to move higher in the near-term. Today’s strong GDP print of 2.4% (ann.) actual vs 1.8% (ann.) expected supports that view.
(3) The Fed is not committed to any further rate hikes — Jay Powell stressed that every meeting is “live” as in, they will determine what to do at each meeting. The market is currently pricing in a ~40% chance of a hike by the November FOMC meeting.
Economic Scenarios
We are cautious on the path of US economic growth and see recession risk, by the end of this year, as the base case.
Market narratives today center upon these core scenarios:
Soft landing, where US GDP growth moderates (between 0.50% to 2.0%, inflation comes down over time (under 3.0% core PCE by end of 2024), and US labor markets remain resilient (unemployment remains below 4.0%). Rates remain high (2Y at 4%+) through 2024. No recession.
Goldilocks, where US GDP growth reaccelerates and we enter a high growth phase on the back of strong labor markets (unemployment unch. at ~3.6%), inflation moderating around 3.0%, a rebound in China (led by pickup in US consumer activity), and a Fed on pause (0 to 1 more rate hikes). Fed begins to cut by 2H of 2024 on improving inflation data (but still above 2.5%). No recession.
Hard landing, where US inflation begins to reaccelerate due to rising real wages with the Fed and other developed market central banks being forced to consider higher rates (higher SEP forecast of inflation and level of rates). In this scenario, the Fed also considers a 2.0% inflation target do-or-die and is willing to sacrifice pain in the labor market (rising unemployment, from 3.6% to 4.0%+) to see it happen. Ultimately results in a recession in 1H of 2024.
Soft-ish Landing, where US sees a pickup in unemployment in the 2H of 2023 as weakness in new orders (PMIs) drives economic weakness as backlogs (PMI) fall. Inventories remain depressed, as consumer spending fails to rebound due to rising unemployment led by auto and housing sector, as real rates elevate the cost of financing and push unit demand lower. Disinflation speeds up, with the Fed having a small window to cut rates before a real recession takes hold. Expect a shallow recession, though tail risk (especially left tail) increases.
Our View
In our Macro Note in December 2022, we laid out our view that the US economy would see a pick up in growth through 2023, driving asset prices higher. Then, due to the SVB crisis in March, we shifted our view in April to expect a recession in the 2H of 2023. The 1H resilience we expected has borne out, but the global economy has changed in meaningful ways since then.
Two points drive our view: (1) that real interest rates are quite restrictive, driving yield curve inversion and creating stress in credit markets; and (2) a sustained period of contracting new order growth, compounded by economic weakness in China and the Eurozone. Those two points drive our outlook of heightened risk of a credit event and a higher chance of a recession by the end of 2023.
(1) Real interest rates are now at GFC-era levels; credit risk is rising in the financial sector. Commercial real estate will drive realized losses at banks, as they seek to roll debt as it matures.
(2) New orders and Backlogs remain weak. Despite a strong 2Q GDP print and a solid durable goods orders report, unless new orders begin to pick up, the diminishing backlogs will result in less demand for labor.
Real Yields — a Lurking Danger
In the aftermath of SVB, the Fed’s decision to raise its SEP and target a higher-still Fed funds rate is sustaining a deeply inverted yield curve. We believe real rates this high (and accelerating) will create further dislocations and increase the chance of a major credit event. Because real rates are simply the nominal yield - inflation expectations (and minus term premia depending on the tenor you’re examining), as inflation continues on its path towards 2.0%, the real rate will move higher.
What’s going on with inflation?
While inflation spent much of last year exceeding estimates, the 3-month annualized rate of inflation is well below 2.0% and has come in below economist projections recently.
We expect disinflation to continue based upon…
(1) Falling car prices — we expect assemblies to continue adding to the stock of inventories at major auto OEMs which will boost car price disinflation.
(2) Weaker demand for fuel — based upon a weaker Chinese consumer and seasonally weaker August and September for US passenger air travel.
(3) Weaker job openings to reduce wage pressure — despite headlines of major Union contract negotiations. In fact, wages and job growth are making significant progress towards being consistent with a ~2.0% Core PCE YoY target.
Asset Class Outlook
Through the rest of 2023 and into the first half of 2024, we expect economic prospects to diminish, putting pressure on the Fed to cut rates. We see the Fed cutting 50-100bp by the end of Q1 2024 if our economic outlook is realized.
Rates should reprice and experience a bull steepening led by a fall in the front end from ~4.9% on the 2Yr to about ~4.0%. The 10Yr will move as well, we expect from ~4.0% to ~3.25%.
Equities will see a repricing as well, with a further divergence between SPX and NDX as cyclical sectors underperform vs. growth sectors. Our year-end target for SPX is ~4000 if our recession thesis plays out, though we think equity markets will see progress from current levels by mid-2024. Industries we think will outperform are value chains around aircraft manufacturing, semiconductors, and cloud infrastructure.
Our risk to equities is that we are wrong and SPX outperforms NDX.
Our view on energy prices is constructive post Q4 2023. We think oil will likely stay within the ~$70-90 range, with a soft-floor thanks to SPR refill activities. We do not like energy as an equity sector, however.
Dollar strength should persist against EM currencies until early winter 2024, and trade in range against EUR and GBP. No comments on the Yen and recent YCC adjustments.
From a tactical asset allocation standpoint, we like pockets of equities (and prefer to be long NDX against short SPX), we prefer the 2Y to the 10Y but like duration in general, are neutral to slightly negative on commodities, and like the dollar vs. EM FX.
For a deeper read on our Equity Strategy, please reach out to us directly by emailing me (wahdy@wahdycapital.com).
Best regards,
Muhammad Wahdy
Portfolio Manager
Wahdy Capital