At a Crossroads: Wile E. Coyote Moment or Soft Landing?
It’s been an eventful first half of 2023 in the financial markets. Through June 30, 2023, we’ve seen a major rebound in equity markets after 2022’s sell-off, which was triggered by the Federal Reserve’s rapidly tightening monetary policy. Despite concerns of instability in the broader financial system in February and March, when several major banks failed abruptly, the financial markets recovered well, and investor optimism has continued to increase. While there are many positives to our current investment environment, warning signs continue to flash. We find ourselves at a crossroads. Is the economy in a Wile E. Coyote moment, hovering midair before plunging downward? Or will we have a soft landing, where the economy slows but avoids a recession?
Through the second quarter of 2023, the S&P Index rose over 15%. The tech-heavy, riskier Nasdaq index has regained nearly all of its 2022 losses and is up 32% year-to-date, while the Dow Jones Industrial Index, which tracks more mature, lower-growth companies, is lagging, up only ~4% year-to-date. Recall as well that in 2022 both bond and equity market were negative. This year, the Bloomberg Barclays US Aggregate Index is up slightly at +.5%.
Bank Failures Were the Initial Consequence of Rapid Rate Hikes: The key question at the beginning of this year was whether the Fed could tighten so much and so rapidly without causing damage to the economy and/or a recession. The answer, at least through the first quarter of 2023, was no. Several major financial institutions, including Silicon Valley Bank and Signature Bank, saw unrealized losses stack up on their bond portfolios as rates increased, which effectively erased their capital cushions. Heightened concerns about the overall financial system caused market volatility, and the Federal Reserve, FDIC and Treasury Department intervened with market support.
As a result of government intervention, the markets regained their footing and attention turned back to whether we would have a recession and when the Fed’s tightening policy would end. Based on the resilience of the labor market, continued economic growth and lower inflation data, market participants began to assume that the US economy was likely to have a soft landing, meaning that there would be no recession, and any economic correction would have minimal negative effects. Despite the Fed’s statements that further tightening is likely, investor optimism that the Fed’s tightening cycle is over or nearly over has improved, as has confidence that major damage to the economy because of the tightening has largely been avoided.
Wile E. Coyote Moment or Soft Landing? Whether we will have a soft landing, or if we’re having a Wile E. Coyote moment, wherein the Fed has pushed the economy off a cliff with its monetary policy tightening, and the economy is hovering mid-air before plunging downward, is a key question. A soft landing was a highly unlikely outcome (a “Captain Sully” landing), as it was anticipated that the extreme Fed tightening would have the usual negative effects, including higher unemployment and a weak job market, credit contraction, housing market weakness as mortgage rates increased, and economic weakness.
While concerns linger, major deterioration has not yet occurred, however it may be simply that the effects of tighter policy have a lag, and we haven’t yet felt the full brunt of the hikes. The key question remains – will inflation come down to the Fed’s 2% target and if so, within what time frame? If this happens rapidly, the Fed can end its rate hikes. If not, the Fed has clearly broadcast its intent to continue to hike until it has real-time evidence that inflation is under control.
Debt Ceiling Deal and AI Exuberance Drove Markets in the Second Quarter: For a change, monetary policy was overshadowed in the second quarter by a surprisingly undramatic bipartisan agreement to raise the debt ceiling, and by investor exuberance around the potential of artificial intelligence. The introduction of ChatGPT and other generative artificial intelligence applications spurred an investor stampede into any type of company considered a potential beneficiary of the artificial intelligence trend.
The current challenge to fundamental investors is that market behavior appears to be more akin to chasing a shiny object versus soberly assessing the potential market opportunity for each company. The strength of a very narrow group of stocks, the high valuations at which they are currently trading, and the potential for reality to catch up with investor hope has created a narrow, unstable market. In these types of markets taking profits often makes sense.
Outlook: At a Crossroads – Risks Remain Elevated: Looking into the second half of 2023 and beyond, risks remain elevated. A pullback in bank lending has the potential to cause overall growth to slow and the Fed has clearly said that it is not done raising rates.
While it’s a relief to many investors to have a strong uptick in market indices, and there are many positives to our current investment environment, market participants appear to be ignoring warning signals. The high level of market confidence combined with the risk of further Fed tightening, an economic correction and high valuations of market-leading companies increase the likelihood of future financial market volatility and create risk for investment returns. Corporate earnings will be a market focus as we move into the second half of the year, as will the resilience of consumer spending, particularly as student loan payments begin again in the fall.
As always, despite the clouds on the horizon, market volatility provides opportunities for investors. While strong markets can feel reassuring, those times can call for more caution as sentiment can change on a dime. A core element of successful investing is to anticipate bumps on the road while remaining focused on the long-term. That way, short-term volatility does not derail long-term success.
Lariat Wealth Management is not soliciting any action based on this material. It is for the informational purposes only. To the extent that it includes references to securities, those references do not constitute a recommendation to buy, sell or hold such security, and the information may not be current. It does not constitute a recommendation or a statement of opinion, or a report of either of those things and does not, and is not intended, to take into account the particular investment objectives, financial conditions, or needs of individual clients. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.
Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. One cannot invest directly in an index. Index is unmanaged and index performance does not reflect deduction of fees, expenses, or taxes.
Lariat Wealth Management is not soliciting any action based on this material. It is for the informational purposes only. To the extent that it includes references to securities, those references do not constitute a recommendation to buy, sell or hold such security, and the information may not be current. It does not constitute a recommendation or a statement of opinion, or a report of either of those things and does not, and is not intended, to take into account the particular investment objectives, financial conditions, or needs of individual clients. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.
Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. One cannot invest directly in an index. Index is unmanaged and index performance does not reflect deduction of fees, expenses, or taxes.