With the Fiscal Responsibility Act of 2023 signed into law, the debt ceiling issue has been resolved until early 2025. Within days of the June 5th X date (the date at which the federal debt limit would be exhausted), Congress passed legislation to temporarily suspend the federal government’s debt ceiling, avoiding a possible government default and allowing the U.S. Department of the Treasury to continue issuing debt to meet its fiscal obligations. As we argued in May, the impact of the debt ceiling drama on capital markets, which was witnessed primarily in the fixed income markets and in short-term treasury securities, has abated. Investors that remained focused on things within their control, such as sustaining a long-term focus, maintaining equity market participation and portfolio diversification, and sticking to their financial plan, successfully navigated the short-term noise and are better positioned going forward because of it.
Given that this tail risk is now in the rearview mirror, we urge investors to focus on several tailwinds that we believe may support the economy and equity markets throughout the remainder of the year. These include the strength of the American consumer, labor market resilience, diminished regional banking stress, improving earnings trends, and a recovering consumer sentiment backdrop. Taken together, these tailwinds are likely to support equity markets and delay a potential recession until 2024, providing for a shallow recession given that inflation is likely to be notably lower than it is today, allowing the Federal Reserve more scope to ease monetary policy. Given this view, investors should maintain equity market participation because the risks of a melt-up remain highly more relevant than a meltdown.
The Strength of the American Consumer
The American consumer has the ability to support consumption, the largest component of gross domestic product (GDP), due to strong balance sheets, the outlook for household income, and their ability to borrow. Excess pandemic savings in 2020 and 2021 amounted to an estimated $2.4 trillion, of which $600 billion to $1 trillion remains. The excess cash, combined with a lower-than-average household savings rate, provides evidence that consumers are utilizing funds to compensate for consumption postponed during the pandemic. While nominal spending growth is likely to slow and the household saving rate may rise as the economy cools, these excess savings could support consumption for another 6-12 months.
The resilient labor market, discussed in more detail in the following section, provides constructive insight into a household’s ability to consume as income growth directly contributes to higher household consumption. As consumer prices continue to normalize at a quicker rate than sticky wages, gains in real disposable income are likely to continue for some time. Chart 1 showcases the fact that workers have experienced ten consecutive months of steady or rising real after-tax income, providing further support for consumption.
In addition to asset and income resources, households can borrow to extend consumption. In fact, we are seeing this play out as credit card balances outpaced their pre-pandemic trend in January 2023. Yet a deeper look showcases that households are not overindebted, are performing well on outstanding debt, and have sufficient ability to borrow more. Chart 2 showcases the financial obligations ratio (calculated as outstanding household credit as a percentage of disposable personal income) which is lower than it has ever been in periods prior to the pandemic.
Labor Market Resilience
The latest labor market data continues to showcase the resilience of the economy and the sustained demand backdrop for labor. In May, the economy added 339,000 jobs relative to the average consensus estimate of 195,000. Two-month net payrolls were also revised higher by 93,000. The Job Opening and Labor Turnover Survey (JOLTS) reaffirmed the demand for labor as job openings rose to 10.1 million in April. Despite a marginal decline in aggregate openings since the peak in mid-2022, the economy offers 1.8 open jobs for every unemployed person, significantly higher than the pre-pandemic average (Chart 3). Moreover, the unemployment rate stands at 3.7%, with jobless claims flattening over the past two months.
The reality of the labor market today is reflecting the same issues experienced during the depths of the COVID pandemic in that economists maintain a dismal and highly irregular understanding of the labor supply and demand dynamics that are likely to materialize. Chart 4 highlights that most estimates lean neutral-to-pessimistic as nonfarm payrolls have surprised to the upside for 13 months in a row. Such a stance has historically increased the near-term risk for an equity market melt-up. This has been especially true when the trend of economic data points carries an upside surprise.
Diminished Regional Banking Stress
In March and April there was much uncertainty surrounding the failure of several U.S. banks, beginning with Silicon Valley Bank, and whether contagion would spread throughout the financial system. We argued at that time that while all banks have been pressured by the current Federal Reserve hiking cycle, the issues that emerged within these failed banks were a result of idiosyncratic risks and not representative of most U.S. banks. Since the Global Financial Crisis, most banks have been well regulated, soundly managed, maintain a diversified depositor and loan base, and remain highly capitalized. Our view has so far proven correct as the impacts of the banking stress have been contained. While lending standards have become more stringent following the bank failures and further Federal Funds rate increases, the imminent fear of a credit crunch has subsided. The longevity of such an occurrence remains up for debate, yet we would argue that it would be unwise to attempt to extrapolate forceful uncertainty.
Improving Earnings Trends
Earnings trends for the S&P 500 are diverging relative to the economic consensus that a recession is near. Given that equity markets are leading indicators, it may provide a signal for further upside. First quarter earnings growth exceeded expectations with earnings declining 3.1% year over year versus pre-season forecasts for an 8.1% decline. Against subdued expectations, 78% of companies surpassed their earnings per share expectations versus the 65% long-term average. Thus, U.S. large cap companies’ earnings recession has been lighter than expected so far. In addition, 12-month forward earnings estimates have risen since April while operating and net income margin compression has begun to subside thanks in large part to declining inflation and cost reductions.
Bearish Yet Improving Sentiment
Given last year’s stock and bond market declines, surging inflation, hawkish monetary policy, and strained geopolitical tensions, it is no surprise that consumer sentiment was leaning bearish. What did come as a surprise, though, was that consumer sentiment hit an all-time low in June 2022, surpassing levels hit during the COVID pandemic and Global Financial Crisis (Chart 5). Given the recovering capital markets backdrop and receding inflationary pressures so far in 2023, consumer sentiment (though low by historical standards) has begun to recover. Such a stance has generally been a strong contrarian indicator for above-average forward stock market returns.
In fact, when looking at the 17 previous lows in the University of Michigan’s Consumer Sentiment Index going back to 1978, subsequent 12-month and 18-month forward returns have been overwhelmingly positive. Forward 12-month returns averaged 22.3% while forward 18-month returns averaged 30.6% with 94% of occurrences providing positive returns. While past performance is no guarantee of future results, it does provide compelling support for subsequent returns through the remainder of 2023.
We urge investors to focus on several tailwinds that we believe may support the economy and equity markets throughout the remainder of the year. These include the strength of the American consumer, labor market resilience, diminished bank stresses, improving earnings trends, and bearish, yet recovering, consumer sentiment. Taken together, along with a lack of prudential economic risks, these tailwinds are likely to support equity markets and delay a potential recession until 2024. Should the onset of a recession be deferred, inflation is likely to be notably lower than it is today. Such a backdrop should permit the Federal Reserve more scope to ease monetary policy, allowing for a shallower and perhaps shorter recession.
The investment implications are simple. Investors should maintain equity market participation because the risks of a melt-up remain highly more relevant than a meltdown. Within domestic equity allocations, investors should focus on individual companies that exhibit solid fundamentals including strong balance sheets and robust revenue, cash flow, and profitability metrics while remaining cognizant of valuations and volatility. Investors should maintain appropriate exposure to international equity markets given their diversification benefits, strong price breadth, attractive valuations, and higher dividend yields relative to domestic equities. Fixed income should be utilized to achieve the investor’s investment objective and should be positioned primarily within investment grade markets such as Treasuries, high quality corporates, and municipal bonds while maintaining a balanced approach between interest rate sensitivity and long-term total return objectives.
Investment advice offered through CX Institutional, a registered investment advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in the presentation may not develop as predicted.
All data is sourced from Bloomberg, through the release of monthly figures from the U.S. Bureau of Labor Statistics or from the Federal Reserve and any of its affiliated regional location.