Investment Strategy
by Larry Adam
Chief Investment Officer, Private Client Group

What will the Fed’s updated dot plots signal to the market?

June 2, 2023

Key Takeaways

• Jobs growth still likely to cool in the months ahead
• Tailwinds to consumer spending coming to an end
• Narrow market breadth not all doom and gloom

Happy National Donut Day! If you have not done so already, make sure you stop by your local donut shop to take advantage of any sweet freebies or promotions that may be going on today. While tempting to think this celebration was started just to promote sales (as if consumers need another reason to shop for or eat donuts!), you may find it interesting to know that the origins of National Donut Day trace back to 1917, when female volunteers from the Salvation Army traveled to France to serve homemade donuts to soldiers fighting on the front lines during World War I – providing a much-needed morale boost for our armed services. And speaking of a morale boost, the passage of the debt ceiling deal this week should remove a key source of uncertainty facing the markets. With the debt deal now out of the way, the market can move back to focusing on fundamentals, such as the jobs market, earnings, inflation, economic growth and the Federal Reserve (Fed). Here’s our latest thinking:

• Still waiting on the recession | For more than a year, the market has been on recession watch. Yet, despite surging inflation, a deeply inverted yield curve, and the most aggressive tightening cycle in nearly four decades, the economy has held up better than expected. Even recent bouts of banking stress were not enough to tip the economy into a recession. While all the ingredients for a recession are flashing warning signals, economic growth, while slowing, continues to chug along. However, with the normal lags in monetary policy, economic growth will slow even further as we move into the second half of the year. Below are two areas we are focused on as the economy appears to be at an inflection point and headed for a mild recession in the back half of this year.
  • Jobs still in a ‘sweet spot,’ but for how long? | U.S. employers added 339k jobs in May, with the unemployment rate rising from a historically low level of 3.4% to 3.7%. Despite a steady stream of layoff announcements, the labor market’s strength continues to defy gravity. While job growth has slowed from an average of ~400k jobs per month in 2022 to ~310k jobs per month today, it remains elevated given where we are in the economic cycle. The unexpected rise in job openings to 10.1 million suggests the job market remains healthy, with 1.8 jobs available for every job seeker. However, hints of a slowdown can be seen in the declining quits rate, which has fallen to levels that prevailed prior to the pandemic, the modest uptick in the weekly claims data and the ~320% increase in the number of job cuts from this time last year reported in the latest Challenger report. Our economist expects the downward trend in job growth to continue and turn negative in 2H23.
  • The consumer’s ‘sugar rush’ may be coming to an end | The tailwinds to consumer spending – excess savings, fiscal support from the government (i.e., pandemic relief, pause on student loan repayments), pent-up demand and a strong labor market – are beginning to fade. Consumers have increasingly turned to credit to maintain their spending, but tighter bank lending standards and weaker job prospects may limit their ability to accumulate more debt. While the consumer is still spending, they are becoming increasingly cautious – hunting for deals, purchasing more affordable options and focusing on essentials – key themes echoed during Q1 earnings reports. And with the pause on student loan repayments set to end in August per the debt ceiling compromise, as many as 45 million Americans will need to start paying back nearly $1.6 trillion in student loan debt. This additional headwind will likely restrain spending even further.
• Does narrowing market breadth have to be an ‘unhealthy’ sign? | The narrow leadership of the market has been a consistent theme this year, with only a handful of mega-cap stocks powering the 10+%advance in the S&P 500 this year. Deeply depressed valuations after last year’s rout, the rising popularity of artificial intelligence (AI) and cost-cutting have been major catalysts behind the move in mega-cap stocks this year. But given narrow participation, with only 27% of stocks trading above their 50-day moving average, many investors remain cautious as sustainable rallies typically require broad participation. While the internals of the market are not signaling broad strength, this disconnect can resolve itself in two ways – either the strong gains from the narrow group of leaders start to fade, or the market rally broadens from here. Given that earnings are holding up better than expected and some of the major headline risks – debt ceiling, banking turmoil, end of Fed’s tightening cycle – are fading, the market’s attention will turn back to fundamentals and could lead to a broadening of participation to the upside.
• Earnings growth is not ‘crumbling’ | Q1 earnings season came in better than expected, supported by positive earnings surprises particularly in the Info Tech sector. A robust 78% of S&P 500 companies beat their earnings estimates and 74% beat their sales estimates, which are both above their five-year averages. Net profit margins also improved, rising from 10.8% to 12.2% as cost-cutting measures helped companies’ bottom lines. These positive surprises have stabilized the decline in 2023 earnings around the ~$220 level, just above our $215 EPS estimate for year end.

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