Q3 Economic Commentary – Tallying the Headwinds and Tailwinds 

2023 thus far could be summed up with two words: Artificial Intelligence (A.I.). Companies with major stakes in A.I., including Microsoft, Google, Nvidia, Meta, and Apple have each posted year-to-date gains of over 40%.  Many investors view this new technology as a game changer for business efficiency and profitability and have piled into A.I. stocks, pushing their earnings multiples to historic highs.  In our commentary below, we analyze the tech sector and more as we detail the headwinds and tailwinds likely to influence the economy and market through the remainder of this year.

Potential Headwind – Technology Dominating Market Gains

Stock performance outside of the A.I. and technology spaces has been more of a mixed bag, with “old world” industries such as energy, financials, and industrials posting modest gains and losses for the year.  “Breadth analysis,” which tries to gauge the health of the stock market, would suggest that the dominance of one sector (technology) versus the rest of the market is a less-than-ideal condition.

One popular way of measuring market breadth is to compare the S&P 500 Index, which gives heavier weighting to the performance of larger, typically tech-centric companies (market-capitalization weighting), against an equally weighted version of the S&P 500.  When the equally-weighted S&P 500 develops a significant lag versus its cap-weighted counterpart, it may indicate market gains being dominated by a handful of large companies while smaller companies are left behind.  Currently, there is a sizeable lag in the equally-weighted S&P 500, but not to the extremes observed during, say, the dot-com bubble of 1998-2000.

Even so, we would prefer stocks of all sizes and industries to participate in market gains.  On balance, if large-cap tech dominance persists, history suggests it could pose a headwind for future stock market returns.

Tailwind – Inflation Has Peaked

Peak inflation is finally in the rearview mirror, with the year-over-year inflation rate, as measured by the Consumer Price Index, dropping from 8.93% at its June 2022 peak to 3.10% in May 2023.  The “core inflation rate,” which excludes historically volatile food and energy prices, peaked in December 2022 at 6.62% and is now sitting at 5.63%.  This is encouraging but, using Fed Chairman Jerome Powell’s own words, “inflation pressures continue to run high, and the process of getting inflation back down to 2.00% has a long way to go.”  Specifically, Powell cites concern about housing costs, which are still rising at an annualized 7.80% clip.

Still, Federal Reserve officials agree that the threat of runaway inflation is behind us and that a pause in interest rate increases will soon be appropriate.  To wit, their “dot plot” in which they publish their future interest rate expectations indicates just one or two more interest rate hikes this year, followed by cuts in 2024 and onward.

On balance, lower inflation and fewer interest rate increases in the future should be a tailwind for businesses, the economy, and stocks, although it may take as much as 18 months for the effects of less restrictive monetary policy to be felt in the economy (more on monetary policy lag here)

Headwind:  Leading Economic Indicators Warning of Recession

Meanwhile, economic indicators we monitor continue to suggest an slowdown developing, and perhaps sooner than later. One such indicator we pay special attention to is the Conference Board’s Leading Economic Index (LEI).  The LEI is a composite of various data points that can help identify a period of recession before it happens.  The LEI itself has a robust multi-decade track record, though its signals can precede an economic slowdown by sometimes over a year.  It considers data such as new business orders, lending conditions, stock prices, building permits, and more.  Below is a chart of the year-over-year rate of change in the LEI (blue) juxtaposed with real GDP growth (gray).

Source: The Conference Board

Based on the trajectory of the LEI, GDP can be expected to turn negative within the next year.  We view weakening economic indicators as a headwind for future growth and stock market prospects.

Too Early to Tell – Consumer Sentiment

The University of Michigan (UMich) runs a monthly survey on current and future economic expectations.  Even though it’s survey data, it’s still considered a valuable tool for predicting the trajectory of the economy.  Here’s why: We know that 70% of the US’s gross domestic product is consumer spending, and optimistic consumers are more likely to spend rather than save.  When spending is strong, there is more incentive for businesses to produce, expand their operations, and create more jobs.  That’s good for the economy.

2022 was a terrible year for the consumer.  Household purchasing power eroded as inflation chipped away at personal balance sheets and fallout from the war in Ukraine created uncertainty as to whether a NATO/Russia Cold War redux was about to start.  As such, the UMich Index fell to its most pessimistic level since the data started being published in 1952.

Source: University of Michigan

The index has rebounded this year, suggesting consumers may start to rev up their spending, stimulating the economy.  We still think it’s too early to conclude anything, as the personal savings rate has been notching higher as well, indicating a dissonance between what consumers are saying versus what they’re doing.  A bullish indicator we’ll look for in the future will be continued improvement in sentiment and a flat or declining personal savings rate.

The Bottom Line

While the stock market has staged an impressive rally this year, indications of a recession are still present.  And we know from history that recessions are historically associated with lower investment returns.  As such, we are continuing to err on the side of caution in our strategies, opting to own more economically resilient stocks and purchasing bonds from high-quality issuers such as the US Treasury.

As always, we will continue to work hard to protect and grow your wealth, and our phone lines are always open at (561) 972-8011 to discuss all aspects of your financial life – investments, taxes, retirement, and all things around and in between.

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