Mid-year Outlook: Preparing for an Eventual Slowdown

In ancient Greece, the Oracles of Delphi were renowned for their ability to see into the future and advise those seeking guidance. But their pronouncements could have been more concise, leaving those seeking counsel still determining what the future would bring. Investors find themselves in a similar position today, except the oracles work at the Federal Reserve. As the second half of 2023 unfolds, the Fed will look for signs that hiring, consumer activity and inflation are cooling in response to interest rate hikes. Since that hasn’t happened substantially by mid-year, we expect another rate hike at the July FOMC meeting. That may turn out to be the final increase of this cycle. Still, policy easing and lower interest rates aren’t likely on the Fed’s radar until 2024, even if the economy slips into a moderate recession.

Leading indicators for the economy still strongly point to a forthcoming slowdown. Still, the prevailing momentum for employment growth and consumer spending should extend through Q3, pushing off the start of this recession until later this year. Incoming readings on job growth and inflation remain key factors for the economy’s trajectory and the future direction of Fed policy.

There are two critical risks investors should remain attuned to as we head into the second half of the year. First, inflation may remain entrenched for the rest of 2023, and economic growth may stagger below trend. In other words, the ominous prospect of stagflation. As economic activity slows and businesses look to cut costs due to falling sales and profits, hiring should cool sharply in the coming months, with eventual job losses later in 2023. Service inflation should also remain sticky over the second half of 2023, keeping overall inflation around 4.0% at year-end – still too hot for the Fed and nearly double the long-run average. We expect a modest recession to carry into early 2024, pushing the unemployment rate up to around 5.5% next year but also helping to bring inflation back to trend.

The second risk is that the Fed may not necessarily be inclined to start lowering the federal funds rate, contrary to the expectations of market participants. Instead, the central bank may effectively employ its balance sheet as a policy instrument to mitigate financial instability while maintaining a comparatively higher federal funds rate relative to the near-zero interest-rate policy from the past decade. A concept called the “separation principle.”

Although investors must contend with macroeconomic uncertainty, the slow, methodical process of removing liquidity will likely continue to pressure financial asset prices in 2023. The constriction of financial conditions suggests a greater dispersion in operating results likely to occur in equity markets. So, how can investors navigate this challenging environment? Focusing on fundamental factors such as the quality and predictability of company earnings, strong return on equity, and durable return on capital. Moreover, given the likelihood of the Fed keeping interest rates restrictive, focusing on companies with positive free cash flow can help investors navigate the economic uncertainty.

While the history of previous recessions and market downturns can provide some guidance to anxious investors, there’s no way to fully eliminate uncertainty from the investing process, especially as turbulent conditions lead investors to question currently held assumptions and frameworks. Past downturns offer investors one essential lesson: invest for the long term in a way that aligns with your risk tolerance. Macroeconomic shocks or market selloffs shouldn’t cause investors to panic. Instead, investors should prepare for the inevitable uncertainty about the future with a well-diversified portfolio.