Juncture Wealth Strategies - April 2023 Market Update

2023 Themes

Key theme for 2023: Disinflation

GDP Growth: Slowing Global GDP Growth

As shown below, the US economic growth is slowing with the potential for a recession. Currently, the US is expected to grow by approximately 1% in 2023. Global and US growth are expected to rebound in 2024.

US Real GDP - January                                                                                                              US Real GDP - March

Recession in 2H 2023

The Conference Board’s Leading Economic Indicator is one of the most heavily used predictors of recession. As shown below, the indicator has been declining for quite some time and has recently hit levels which predict a recession.

                                                                                        US Leading Economic Indicators - Recession Levels

Recession in 2023: Yield Curve Inversion

Another popular recession indicator is the shape of the US Treasury (UST) yield curve. The yield curve graphs the relationship between UST yields and the time to maturity (i.e., 1 month to 30 years).

Typically, the yield curve is upward sloping so that longer term bonds compensate investors with higher yields. However, the yield curve can “invert” where short term bonds pay higher yields than longer term bonds.

Recession in 2023: Yield Curve Inversion

An important development is that the Treasury real yields (adjusted for inflation) show a different outcome. It shows a flat to mildly positive curve which means the market expects disinflation and a soft economic landing.

Inflation: Monthly Composition

Viewing inflation on a month-to-month basis can provide additional insight as to how inflation is progressing. As shown below, it looks as if inflation may have peaked in June as all components particularly energy experienced lower pricing pressures. Commodity prices have come down significantly over the past few months which has moderated goods inflation. That said, shelter inflation is usually reported with 6- to 12-month lags. Anecdotal evidence suggests that shelter inflation will decline as housing price and rent growth have begun to decline. The US may begin to experience disinflation. A critical question for the markets is the pace and magnitude of the drop in inflation.

Inflation: Composition

Viewing the components of inflation can provide additional insight as to how inflation is progressing. As shown below, Food has been the largest contributor to inflation over the past year. Drilling down on Food, we see that Cereals and Beverages had the highest inflation while Eggs have received the most media attention. Transportation services and Shelter were another two areas contributing to overall inflation.

Inflation: Long Term Expectations

Short term inflation can be painful for consumers as the cost of certain goods and services increase. The most problematic inflation for the economy is long term inflation as inflation expectations can become imbedded via contracts, employment, leases, etc. Inflation can become a self-fulfilling prophecy as workers demand higher wages to pay for higher costs which then get passed back to the worker via higher costs. Fortunately, inflation expectations have declined over the year. Future inflation rates are well anchored at 2%. Over the next year, inflation will decline, but the amount and timing of those declines are critical for the investment markets.

 Inflation: Jobs

The number of job openings in relation to the number of workers unemployed currently has 1.7 jobs for every unemployed worker. To put this number into context, the average for the past 20 years is 0.65. The job market continues to be very tight. The Fed will need this ratio soften dramatically.

Interest Rates: Expected Path

The expected path of interest rates is shown in the graph. It is expected that interest rates will rise to 4.5 - 5.0% in mid 2023 which means the Fed may raise rates by another 1% to combat inflation. The higher rates and tighter liquidity is expected to slow economic growth. Interest rates are expected to begin declining in mid 2023. If inflation remains more resilient, the Fed may continue to raise rates beyond current expectations. Market participants expect GDP to soften significantly and, as such, the Fed will be pressured into lowering interest rates to support economic growth. It is unlikely that those rate decreases will happen if inflation persists above the Fed’s target range.

Interest Rates: Expected Path

The Federal Reserve’s Dot Plot which indicates each FOMC member’s forecast for the target Fed Funds rate at year end. As shown, the members’ median forecast (blue dots) vary significantly from the market’s forecast based on the futures contracts (red dot).

Liquidity: Shrinking Fed Balance Sheet Means Less Liquidity

The Fed has shrunk its balance sheet via quantitative tightening and investors are concerned about QT’s potential impact on the financial markets. It has reduced its balance significantly since mid-2022 which has reduced liquidity. These tightened conditions have begun to reveal weakness among some regional banks. We do not believe this is systemic crisis.

Liquidity: Tightening Financial Conditions

Liquidity across the US financial markets have contracted year-to-date due to higher rates, quantitative tightening and banking turmoil. If liquidity leaves too quickly, it may disrupt the normal functioning of certain parts of the stock and bond markets.

Deposit Runoff: Reasons for Banking Turmoil

Liquidity across the US financial markets have contracted year-to-date due to higher rates, quantitative tightening and banking turmoil. If liquidity leaves too quickly, it may disrupt the normal functioning of certain parts of the stock and bond markets. A major reason for the banking turmoil is depositors taking deposits to either use them (SVB Financial) or to invest in money market funds (First Republic, Signature Bank). As shown below, Treasury yields are much higher than deposit rates. Banks will need to narrow this difference to retain deposits. This may mean that average loan rates will be increasing as banks attempt to defend interest spreads.

Asset Class Performance Year-To-Date

It can feel like we are experiencing a tough 2023 so far. Certain asset have performed well such as bonds, developed international stocks, and large US stocks. January was a terrific month for small cap which has trailed off over the past two months as the regional bank crisis and technology layoffs have hit those asset classes.

Sector Performance Year-To-Date

In terms of US Sector performance, the leaders of 2022 have turned into the laggards and vice versa. In 2022, Energy and Utilities lead the way while Technology, Communications and Consumer Discretionary were the worst laggards. In 2023, Technology, Communications and Consumer Discretionary are leading and Energy and Utilities are the worst laggards. This change has to do with the banking turmoil and interest rate uncertainty.

Equities: Earnings Growth Expectations

Quarterly earnings per share for the index is expected to grow from mid 40s to $60 by mid 2024. As shown below, earnings are expected to continue to climb unabated. We expect earnings to be revised lower if the Fed continues to raise rates and/or US enters a recession.

Summary

• Global GDP growth is slowing with the US at risk for a recession in second half of 2023 if the Fed continues raising rates.
• Fed is withdrawing liquidity via shrinking its balance sheet and raising interest rates. Markets expect an additional 0.25% in rate increases albeit at a much slower pace as the Fed has to balance maintaining financial stability versus fighting inflation.
• Inflation is expected to decline to more reasonable levels as 1) supply chains catch up with demand, 2) interest rate increase dampen consumer spending, and 3) excess liquidity is withdrawn. Forward inflation is expected to decline to the 2-3% range. Disinflation will become a key narrative.
• Labor market may weaken as employers begin to reassess their staffing needs by canceling job opening and “right sizing” their operations.
• Potential liquidity problems may appear in certain risky investments (or banks) which may cause high volatility.
• USD weakening may be supportive of any investments denominated in other currencies.
• Various countries’ bellicose postures - Russia, China, Iran and North Korea – may cause geopolitics to return to the forefront.

Expect 2023 to be a year of transition with decent returns from global stocks. As shown above, we expect current leadership to start the transition from stocks which are US-based, have large capitalizations, and exhibit value characteristics to begin to include stocks which are international in scope, have smaller capitalizations, and exhibit more growth characteristics. Additionally, the US dollar may decline which will support international and commodity investments. Bonds may perform better than stocks during the first half of the year but may underperform stocks during the second half as stocks predict economic recovery.

Disclaimer: This newsletter is provided to you for informational purposes only. Any specific firm or security presented should not be construed as an endorsement or recommendation by Juncture Asset Management, LLC. No advice may be rendered by Juncture Asset Management, LLC unless a client service agreement is in place. Please consult with your financial advisor before making any investment. Information provided by Bloomberg is believed to be accurate but has not been verified.