Midyear 2023: What’s driving today’s resilient economy?

SO FAR, 2023 HAS BEEN THE SORT OF YEAR to make even seasoned financial observers scratch their heads. As the U.S. grapples with stubborn inflation, a sharp rise in interest rates, and lingering effects of the pandemic, some sectors of the economy are defying widespread predictions of a slowdown.

Are we headed for the recession everyone’s talking about? If so, why are consumers still spending and companies still hiring? And what steps could investors take from here? For answers, we turned to Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank. Here, Hyzy shares his thoughts on everything from current market volatility to the new era of growth he believes may start in the year to come. For more on the Chief Investment Office’s outlook, see “When Oceans Collide”.

Q: Considering last year’s historic market challenges, what has surprised you most in the first half of 2023?

A:  The word that comes to mind is resilience. After one of the worst years ever for both stocks and bonds, markets have bounced back, particularly in the technology sector, which was battered in 2022. In another surprise, corporate earnings have held strong, despite predictions they would weaken. And the job market and the service economy have proven to be remarkably resilient. Finally, even as the Federal Reserve has been raising interest rates to combat inflation, liquidity and financial conditions across the capital markets have held up well, and even balanced out some of the more difficult challenges in the broader economy.

Q: What’s the likelihood of a recession this year? Will investors see the soft landing they hope for?

A: This is one of the most highly anticipated recessions ever and one of the hardest to track.  Instead of a single, economy-wide downturn, we're seeing what amounts to a rolling series of smaller recessions as different sectors experience the aftereffects of historic liquidity pumped into the economy during the pandemic. The housing market and manufacturing have already bottomed out. We’ll be watching consumer savings and spending, the labor market, services, and corporate earnings in the second half of the year. If spending weakens, companies’ pricing power and earnings growth may decline. As different sectors weaken and recover at their own pace, we may see a series of soft landings through the rest of the year.

Q: What’s behind the resurgence in technology, and how has that affected wider market performance?

A: Since late last year, tech companies have shown a new willingness to cut costs. Earnings have stopped declining and revenues, while not at pandemic levels, have surpassed expectations. As longer-term interest rates have stopped rising and come down, money has poured into technology and growth stocks in general. Among S&P 500 sectors, tech represents the largest share of earnings and is the largest sector by market capitalization. It is also, of course, the dominant sector on the NASDAQ Composite Index. All told, a relative handful of tech stocks have accounted for much of the market growth so far in 2023.

Q: Are you concerned that so few companies account for the market’s strong performance?

A: Investors and market strategists tend to worry about market breadth whenever a narrow set of companies drives market performance. Certainly, there are short-term concerns; if some or all those companies are hit by unexpected setbacks, the rest of the market must work overtime to compensate. But over the longer term, studies show no discernible difference in performance when either narrow or wide sets of companies drive the market through bear or bull cycles. We don’t see this as a major concern right now, especially since the largest tech companies continue to exhibit high-quality earnings.

Q: What’s ahead for equities in general for the rest of 2023 and beyond?

A: Investors should expect periodic volatility in the coming months as markets grind through the recession uncertainties we’ve discussed. This underscores the importance of staying diversified across equities, with an emphasis on large, high-quality companies. With periods of weakness likely ahead, investors may want to consider investing a set amount at regular intervals (known as dollar-cost averaging) enabling them to buy relatively more shares when markets are lower.

As interest rates and inflation stabilize, we expect to emerge by mid-2024 into a new, extended bull market cycle, driven by innovation and productivity. This should present potential long-term opportunities in areas such as renewable energy, industrial automation and robotics, and artificial intelligence (AI). Energy, materials and other industries should also benefit from re-shoring, as companies emphasizing regional rather than global production require new factories and other infrastructure.  We believe small-caps stocks will likely be strong beneficiaries of these various trends that are just beginning.  And demand for commodities and base metals – which will be highly needed in the future — could benefit select emerging markets.

Q: Generative AI has captured a lot of attention. What opportunities do you see for investors?

A: Generative AI, technology capable of producing original content, has major implications across sectors. It should enhance productivity and make companies more profitable. And while some worry it will destroy jobs, our view is that it will instead fill labor gaps, enabling workers to do other things. Still, generative AI is very early in the cycle from development to commercialization. So, investors should watch closely and await potential opportunities.  While people tend to think first about software, we believe the greatest initial opportunities will be in hardware and infrastructure needed to support AI.  That could mean companies providing data speed and transmission, as well as newer and better semiconductors and telecom equipment.

Q: Where does the Federal Reserve’s (the Fed’s) battle with inflation stand, and what’s ahead for interest rates?

A: After more than a year of historic rate hikes, the Fed declined to raise interest rates in June, a sign that inflation is headed in the right direction. Remarkably, in about 15 months since the Fed’s campaign began, inflation gauges have moved from better than 9% to approximately 4.5%. Breakeven inflation (a projection of long-term trends) is getting closer to the Fed’s target rates of 2%. We could be there by the end of 2024. In the short term, inflation is proving to be a bit sticky, especially given the still-hot labor market and rents. And the Fed has signaled additional rate increases this year. But the long-term trend is headed in the right direction, and we believe markets are already factoring that in.

Q: What should bond investors be thinking about right now?

A: For the first time in years, investors can look to bonds not just for portfolio diversification but for income. That was the missing piece during years of near-zero interest rates. The tradeoff is that rising rates drive down bond prices. So, capital appreciation, which bond investors have long enjoyed, has become a secondary concern.

Current conditions favor short-duration bonds, since the yield curve remains inverted (when short-term rates are higher than long-term rates) in expectation of a recession. Investors might consider laddering — investing in a series of short-term bonds with progressive maturity dates, providing steady income while capturing current higher rates. Over the next six months, it may make sense to consider longer-term bonds to lock in long-term yields, before rates start to decline.

Q: What should investors discuss with their advisors as they prepare for the second half of 2023 and beyond?

A: Despite everything going on in the wider economy and markets, it’s important to remember that investing is personal. The best place to start that conversation is with your goals and what you’re ultimately trying to achieve. Then you can talk about portfolio strategy and any changes you need to make based on revised goals or short-term market forces. The portfolio of the future needs to be more diversified both across and within asset classes, including stocks, bonds and, for qualified investors, alternative investments. But it all starts with having a clear understanding of your goals.