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Market Outlook

Still Waiting for Recession

2023 Midyear ETF Market Outlook

The most popular prediction headed into 2023 was that markets would suffer through a rough first half but rally by year’s end. However, stocks and bonds have refused to comply with the consensus forecast.

Throughout the first four months of the year the S&P 500 Index has climbed by more than 9% and the Bloomberg US Aggregate Bond Index has gained 3.6%, resulting in a rebound of the traditional 60/40 portfolio.1 A welcome reprieve after last year’s capital market losses.

Resilient Market, Weakening Economy

There has been plenty of bad news this year that could have derailed the first half’s rally in risk assets.

  • Further tightening monetary policy, the Federal Reserve (Fed) has raised interest rates at all three of its meetings this year and ten times overall since last March. As a result, the economy is showing some signs of cooling but inflation is still too hot.
  • Year-over-year earnings have declined for two consecutive quarters on smaller revenues and shrinking profit margins.
  • Several US banks have failed amid the ongoing crisis in the regional banking industry, raising fears of a looming credit crunch.
  • Debt ceiling negotiations in DC were particularly divisive before resulting in a deal to avoid default. 
  • China’s reopening from COVID restrictions has been underwhelming.
  • And, sadly, the Russia-Ukraine war rages on with no clear end in sight.

So, it must be maddening for market prognosticators to watch stocks and bonds continue to climb the proverbial wall of worry. The widening gap between financial assets’ performance and underlying risks underscores the notion that the economy is not the market and vice versa.

Investor Anxiety and Skepticism Build

Investors are on edge — eager to protect their unexpected gains. Like Vladimir and Estragon from Samuel Beckett’s play Waiting for Godot, investors are anxiously awaiting the titular recession that may or may not arrive this year.

Most economists expect a recession in the next 12–18 months. And investors crave clarity regarding its timing and severity. But until the resilient consumer and strong labor market falter, investors will likely have to wait a while longer for the anticipated recession — which might take a few more quarters to unfold. According to Strategas Research Partners, there has never been a market bottom before a recession began, further fueling investors’ anxiety.

Meanwhile, a look beneath the surface of the solid year-to-date performance of the S&P 500 supports investors’ growing skepticism regarding the rally’s durability. While the S&P 500 is near its year-to-date high of roughly 4,200, just 51% of constituents are above their respective 200-day moving averages.2

The index bottomed more than seven months ago in mid-October and, by this stage of the rally, participation should be meaningfully broader. A majority of the S&P 500’s performance this year has been driven by just a handful of stocks.

For example, together, Apple and Microsoft are valued at almost double the combined market capitalizations of the entire Energy and Materials sectors.3 Apple itself is worth more than the Russell 2000 Index and J.P. Morgan is worth more than all publicly traded regional banks.4 The performance difference between the equal-weighted S&P 500 Index and the NASDAQ 100 Index is at a statistically extreme level.5

Breaking Through the Market’s Ceiling

The S&P 500 has struggled so far this year to meaningfully break through the 4,200 level. So, what’s it going to take for the index to break through the ceiling and continue the rally in risk assets?

A definitive end to the Fed’s tightening cycle could help. But the Fed is in a difficult position, and investors are uncertain about the future path of monetary policy. Inflation remains significantly above the Fed’s target and the labor market hasn’t been this strong in more than 50 years. This would suggest the Fed should keep raising rates. But, the regional banking crisis combined with Fed officials’ own words and actions have investors convinced the tightening cycle is over.

Historically, during the monetary policy transition period between the last rate hike and the first rate cut, risk assets perform reasonably well. In fact, that may reflect the current investment environment. But be wary of rate cuts, because risk assets typically fall when the Fed starts cutting. Afterall, the Fed is lowering rates for a reason — usually in response to a recession or capital market breakdown.

Gaining insight into the direction of monetary policy will be key to breaking through the market’s ceiling. The good news is, the picture should become a lot clearer in mid-June at the next Fed meeting.

Finally, the bipartisan bill to raise the debt ceiling just signed into law by President Biden will likely support the continuation of this year’s rally. 

The Essential Doesn’t Change: Look to Diversify

Clarity on the timing and severity of recession, insight into the direction of future monetary policy, and the agreement to raise the debt ceiling hopefully will result in more stocks participating in this year’s rally — finally enabling markets to break through the ceiling.

While we wait, the range of potential market outcomes has never been wider. That makes diversification — a strategy that helps portfolio performance when the unexpected happens, like in the first four months of 2023 — more important than ever.

With caution and courage, consider these three strategies when constructing investment portfolios for the second half of 2023:

  1. Move up in quality in the US and rotate overseas
  2. Seek income and balance risks with bond ETFs
  3. Diversify recession risks with cyclicals and defensives


Bio Image of Michael W Arone

Michael W Arone, CFA

Chief Investment Strategist

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