The Second Half of 2023 May See an Uptick in Volatility
/A couple of weeks ago Clearwater Capital released our full Mid-Year Update report of our Outlook 2023. Even as the U.S. equity markets continue to rally, we remain cautious. Our base case calls for a short and shallow recession to develop later this year, or early in 2024.
Last week, the Fed raised interest rates by another 25 basis points as was widely expected. This brings the total number of rate hikes to eleven over the past 16 months. As of this writing the futures market suggests a 50% chance that the Fed will raise rates once more before the end of the year. While Fed Chair Jerome Powell was characteristically vague at his press conference following the FOMC meeting, one can assume that further tightening is likely as long as inflation runs at levels above the Fed’s target of 2%.
While the rate of inflation has been declining since hitting a high of 9.1% a year ago, one must remember that this does not mean prices are coming down – only that the pace in which they are increasing has slowed. The cumulative total inflation now stands at 16.6% since January 2021 when the rate of inflation started to accelerate. This simply means that consumers must now spend $1.17 to purchase the same items that cost $1.00 just two and a half years ago.
Equity markets appear to be increasingly convinced that the Fed will bring inflation down without triggering a recession. This is referred to as a “soft landing” and we remain skeptical. Because of the lagged and varied impact of higher interest rates, we believe the degree to which the economy will eventually slow will be greater than many investors currently expect.
Mortgage rates remain elevated, the leading economic indicators have been declining for fifteen straight months, consumer debt is trending towards all-time highs, and corporate bankruptcy filings are double what they were at this point in time in 2022. WTI crude oil prices have risen steadily over the past month with the price per barrel now over $80. This, and the persistent strength in the services sector, will make further declines in inflation more difficult to come by in the months ahead.
On the bright side, corporate earnings have remained resilient and consumer confidence recently ticked up. Equities have had a nice rally this year, but the indices have been dominated by a handful of mega cap tech companies with exposure to artificial intelligence. Another positive for the economy is the narrowing of corporate bond spreads over Treasuries. However, most yield curves are significantly inverted which historically signals trouble for the economy.
Our view is the Fed’s battle with inflation will be quite challenging in the second half of the year, causing policy makers to keep interest rates higher for longer than is widely expected. This, along with a wide range of trends that are likely to pinch U.S. consumers in the months ahead, leads us to believe there could be trouble for the economy later this year. We think risk assets could be vulnerable when this becomes apparent to investors who have bid equity prices to their highest levels in over a year.
Please refer to our Mid-Year Update for a detailed discussion of current conditions.
John E. Chapman
Chief Executive Officer
Chief Investment Strategist
