June 2023 / MIDYEAR MARKET OUTLOOK
2023 Midyear Market Outlook: Finding the Signal Through the Noise
INTRODUCTION
Reluctantly Bearish
Moving into the second half of 2023, the balance of economic forces still appears tilted against global capital markets. Sticky inflation, central bank tightening, and financial instability all pose clear risks.
Yet, through late May, economies and markets both showed surprising resilience. Growth remained positive in the major economies (Figure 1), and earnings results came in stronger than expected. Key equity markets posted gains.
These results appeared to validate the wisdom of a “reluctantly bearish” approach. Bearish, because the risks are substantial. Reluctant, because excessive pessimism can lead investors to overlook opportunities and miss market recoveries.
It’s an open question whether economies and markets can continue to defy the pessimists in the second half, says Sébastien Page, head of Global Multi‑Asset and chief investment officer (CIO).
Many economic indicators, Page notes, are flashing red. But lingering distortions from the COVID pandemic make it hard to distinguish the signal from the noise—the useful information from the meaningless data points.
The strongest bear argument, Page says, is that the economic impact of 500 basis points (bps) of interest rate hikes by the U.S. Federal Reserve has yet to be fully felt. “Every time the Fed has slammed on the brakes in the past, someone’s head has gone through the windshield,” he warns. “And we’ve already found out that some banks weren’t wearing their seat belts this time.”
Although the banking crisis appears contained, its impact on credit conditions will be felt with a lag, notes Arif Husain, head of International Fixed Income and CIO. Resolution of the political dispute over the U.S. debt ceiling also could squeeze market liquidity in the second half, he says, as the U.S. Treasury rebuilds its depleted cash account at the Fed.
Yet, opportunities can be found in select sectors, including small‑cap stocks and high yield bonds. Cheaper valuations and a weaker U.S. dollar also could make global ex‑U.S. equity markets attractive, says Justin Thomson, head of International Equity and CIO. Positive yield curves could do the same for global ex‑U.S. bond markets, Husain adds.
In an uncertain environment, careful security selection will be critical. “Skilled active management can help investors avoid riskier exposures,” Page argues.
Growth Has Slowed but Major Economies Are Not in Recession—Yet
(Fig. 1) Growth in real gross domestic product (GDP), year over year
As of March 31, 2023.
Sources: Haver Analytics/U.S. Bureau of Economic Analysis, Statistical Office of the European Communities, Cabinet Office of Japan, Japan Ministry of Internal Affairs and Communications, International Monetary Fund.
Explore our three themes:
1. Economic Resilience Tested
The global economy avoided recession in the first half of 2023. The second half will bring further tests as the impacts of higher interest rates and tighter liquidity are fully felt.
2. Bonds Are Back?
An inverted yield curve means investors may want to think twice before aggressively jumping into longer‑term U.S. bonds. Credit sectors and global ex‑U.S. markets offer return potential.
3. A Focus on Earnings
Earnings growth estimates have come down but may need to fall even more in the second half. Still, there are opportunities in U.S. small‑cap stocks, mega‑cap technology, and global ex‑U.S. markets.
Summary
Entering 2023, T. Rowe Price investment leaders argued that fears of a deep global economic downturn were exaggerated. Pessimism, they suggested, could create contrarian opportunities. As of late May, both propositions appeared correct:
- Recessions in the U.S. and Europe, widely predicted at the start of the year, had yet to materialize.
- Major equity markets in the U.S., the eurozone, and Japan showed positive year‑to‑date returns.
- Default rates remained low, supporting attractive returns on high yield bonds.
“So far this year, the good news has roughly outweighed the bad news,” Husain says.
The market consensus still seems to foresee a global recession starting later this year or early 2024, but now expects it to be mild, Thomson says. However, “I think markets also understand that the biggest tail risk is a credit crunch leading to a much deeper recession.”
A list of economic and financial paradoxes has made it hard to estimate that risk, Husain notes. Resolution of the U.S. debt ceiling dispute avoided one potential crisis but could tighten liquidity in the second half. Low unemployment helps support consumer demand, which is positive for earnings, but is potentially negative for inflation and interest rates. Reflation in Japan is good news but could lead the BoJ to decontrol yields, which would be bad news for other global markets.
Given these uncertainties, and the low “signal‑to‑noise ratio” in the data, it’s no surprise that interest rate volatility has remained high (Figure 8). It’s likely to remain that way, Husain says.
From an asset allocation perspective, however, investors should remember the longer‑term historical record, Page says. “U.S. stocks have outperformed U.S. bonds 67% of the time, on a rolling 12‑month basis, by an average of seven percentage points5,” he notes. “That’s based on over 80 years of data.”
That record is one reason Page describes himself as a “reluctant bear” on U.S. equities, despite high valuations and a poor earnings outlook. It also shapes his overall market view: “My takeaway fits in a fortune cookie,” he says. “Stay invested; stay diversified.”
Market Volatility Is Likely to Persist
(Fig. 8) Implied volatility measures
As of June 1, 2023. Past performance is not a reliable indicator of future results.
Interest rate volatility = MOVE Index, which represents implied volatility on 1‑month Treasury bill options. Equity volatility = VIX index, which represents expected volatility of the S&P 500 Index. Credit volatility = high yield 3‑month implied volatility, which represents expected future volatility of the iShares iBoxx High Yield Corporate ETF. This exchange‑traded fund is shown for illustrative purposes only to demonstrate high yield volatility.
*Values rebased to December 1, 2020.
Source: Bloomberg Finance L.P. All data analysis by T. Rowe Price.
5 Stocks based on Ibbotson® SBBI® US Large-Cap Stocks from 1926 to 1939; S&P 500 Index from 1940 to present. Bonds based on Ibbotson® SBBI®US Intermediate-term Government Bonds Index from 1926 to 1975; Bloomberg U.S. Aggregate Bond Index from 1976 to present. Rolling monthly observations January 1926 through April 2023.
Past performance is not a reliable indicator of future results.
2023 Tactical Allocation Views
*For pairwise decisions in style and market capitalization, boxes represent positioning in the first asset class relative to the second asset class. The asset classes across the equity and fixed income markets shown are represented in our multi‑asset portfolios. Certain style and market capitalization asset classes are represented as pairwise decisions as part of our tactical asset allocation framework.
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Arif Husain is the head of Global Fixed Income and chief investment officer of the Fixed Income Division. He is chairman of the Fixed Income Steering Committee and a member of the firm’s Management Committee. Arif is lead portfolio manager for the Global Government Bond High Quality Strategy. He is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price International Ltd.
Sebastien Page is head of Global Multi-Asset and Chair of the Asset Allocation Steering Committee, which is responsible for management and oversight of the Multi-Asset Division. Before joining our firm Mr. Page was Executive Vice President at PIMCO.
Justin Thomson is the head of International Equity and a co-head of Global Equity. Justin is a member of the Management Committee, the chairman of the International Equity Steering Committee, and a member of the Asset Allocation and Environmental, Social, and Governance Committees. He also is the chief investment officer for International Equities.
