It’s worth remembering how unusual the first three years of this decade have been compared to the 2010s. The world faced a once-in-a-century pandemic with unprecedented economic lockdowns along with massive monetary and fiscal stimulus. The stimulus and the cost to reopen global economies and restore supply chains fueled the sharpest sustained surge in global inflation in 40 years.
The response was the most aggressive global interest rate hike cycle in decades, with consequences that included a rout in the capital markets in 2022, a minor banking crisis, tighter credit conditions, and widespread forecasts of a recession this year or next.
Now, investors are trying to figure out the puzzle of ongoing monetary policies, inflation expectations and growth prospects. Putting the pieces together has not been easy or without hurdles. Yet, the long-term economic growth prospects appear solid, while investment returns in the capital markets have been surprisingly positive this year.
U.S. economy resilient as job growth continues
While growth has been unpredictable, the economy has shown remarkable resiliency. On the plus side, employment remains the linchpin between growth and a potential recession. The economy has created 1.6 million new jobs this year alone and nearly 4 million new jobs since June 2022. At the same time, the nation’s unemployment rate has continued to moderate at around 3.7%, a near-historic low.
Demand for workers remains strong, particularly in services sectors, such as restaurants and travel. Other professional sectors like engineers and computer programmers remain in high demand as the Artificial Intelligence (AI) craze ramps up. The number of jobs yet to be filled remains very high at around 10 million. While wages have risen modestly at about 4.5% annually, they have not kept pace with inflation.
Although jobs are relatively plentiful, consumers are beginning to pull back on their spending habits. The drumbeat of an impending recession and higher prices for everyday items has left consumers exhausted and with less discretionary income.
Manufacturing, homebuilding and banking sectors struggle
While certain areas of the economy remain strong, other sectors are struggling. The manufacturing sector, which surged during Covid, has fallen hard from lower demand and higher prices. The manufacturing index fell to 46 from 48 at the beginning of the year and a high of 64 just a few years ago. A reading below 50 indicates a contraction and overall weakness in manufacturing.
Homebuilding is another area that remains quite volatile. Interest rates have doubled from a few years ago and home prices remain high, which has resulted in about a 40% higher mortgage payment for new home buyers. Homebuilders have struggled with higher mortgage rates, fickle buyers, and volatile input costs.
Yet, building activity has started to pick up recently, with housing starts hitting 1.63 million annually, the highest since May of last year.
Finally, the default of three regional banks this year is a reminder of the impact higher interest rates and moderating business activity has had on the banking sector. While these defaults appear isolated and unique, credit standards have tightened, and banks have generally reduced their investment activity.
Top 5 stocks generate 70% of S&P 500 returns
In this environment, the Federal Reserve has remained steadfast in keeping interest rates elevated to cool historically high inflation. Already, the Fed has raised short-term interest rates three times this year and indicated further rate increases could be necessary.
This backdrop led to solid returns across most areas of the capital markets this year. For the second quarter, the S&P 500 Index returned 8.74%, while the Dow Jones Industrials Index posted a 3.97% return. Large, mega-cap technology stocks led the way, while more value-oriented ones posted only modest returns. The top five S&P names comprised approximately 70% of the returns for the index for the year.
Returns for many small- and mid-cap sectors were underwhelming, with flat or slightly negative quarterly returns. International and emerging market stock sectors produced only modest returns. Interest rates rose modestly, putting some pressure on the quarter’s bond returns. Still, for the year’s first half, both bonds and stocks produced solid investment results.
Looking ahead, the direction of inflation and the action by the Federal Reserve are the keys to determining the near-term outlook for economic growth and trends in the capital markets. As measured by the Consumer Price Index, inflation has fallen consistently throughout the year and is trending toward a more normal range.
However, several cross currents could reverse these positive inflationary trends, including geopolitical issues, a strong employment picture or renewed supply chain delays. Still, the economy’s underpinning appears stable, even though higher interest rates and elevated inflation continue to impact more credit-sensitive areas of the economy. It seems the worst of the inflationary spike is over, and a more normal environment is ahead in the coming quarters.
Since the capital markets are forward-looking, we expect more modest and broad-based returns across most stock sectors, not just large technology names. We also expect interest rates to continue to moderate, which should produce solid results for most areas of the bond market.
Chris is the President and Chief Investment Officer (CIO) of Advance Capital Management. As CIO, he directs the strategy and structure of the discretionary model portfolios and leads the investment committee.