Allen Sinai, PhD, CEO and chief global economist at Decision Economics, Inc., a financial advisory firm based in Boston and New York City. He has been an adviser to several US presidential administrations. DecisionEconomicsInc.com
Welcome to this summer’s heavyweight main event. In one corner—the US stock market weighing in at about $45 trillion and looking to rebound from last year’s bear market as the economy expands. In the other corner—the mighty Federal Reserve, which has embarked on one of the most aggressive interest rate hikes in history to tame runaway inflation. The winner of this confrontation, says economist Allen Sinai, PhD, will determine how investors fare this year.
His forecast: A split decision. Data suggest the Federal Reserve may be able to slow the economy without causing significant job loss and a painful recession. But inflation still remains too high, which means less incentive for the Fed to cut interest rates to potentially spark a new bull market. Looming over this—a banking crisis that threatens to derail economic growth in the second half of 2023 or early 2024. Dr. Sinai cautions investors to prepare for a tilt-up market in which the major indexes fluctuate within a trading range but do advance. Here’s what he sees ahead…
My biggest concern this year was that an overzealous Fed would tank the economy. While a recession would help bring down inflation, it also would damage the stock market. Since March 2022, there have been 10 consecutive short-term interest rate increases, the largest and fastest tightening cycle in 40 years. That has worked to double mortgage rates and send costs of auto loans, credit card borrowing and business loans soaring. The good news: I think the Fed will be able to pull off a soft landing, continuing growth of the economy and moderating inflation while still allowing good growth of jobs. Reasons we can skirt a recession…
Short-term interest rates likely have peaked for now in the 5%-to-5.25% range. The Fed has seen clear enough signs of an economic slowdown and diminishing inflation to justify pausing rate increases. While inflation is still running high—the Consumer Price Index (CPI) was 5% in April 2023 year over year—it has cooled from the 9% inflation rate shock a year ago. Lagged negative effects are still to come, but by stopping now, the Fed hopes not to overdo the tightening.
The strength of the US labor market continues to support economic growth. Even after multiple rate hikes, the unemployment rate in April stood at 3.4%, full employment, the lowest since 1969. The demand for labor has given workers leverage to demand higher wages. Consumers are enjoying rising real incomes and strong balance sheets, so they can handle higher prices without drastically cutting spending.
Continued strong tech spending as the economy shifts to a “techno-centric” structure at all levels in all sectors.
Stronger-than-expected growth overseas. I expect foreign gross domestic product (GDP) to grow at a 3% pace in 2023 and 4% in 2024. Japan is recovering nicely. Canada, Europe and the UK all are expanding. China’s economic growth rate will hit over 5% in 2023…and India, now the world’s sixth-largest economy, will grow at 5½% to 6%.
Despite my optimism, I am still carrying a 35% chance of recession in the second half of 2023 or first half of 2024 due to adverse developments, including…
Federal budget. Fundamentally what is needed are deliberations and planning to resolve outlays for entitlements, government spending and taxation. If not, the deficit could cause a recession.
Banking system turmoil and credit restraint. Several big regional banks failed this year in part because they weren’t prepared for the havoc rising interest rates wreaked on their balance sheets. Even if this contagion doesn’t spread, I’m concerned that financial institutions around the country will tighten the supply of credit, making it harder for individuals and businesses to take out loans and making repayment of maturing loans difficult.
Even if the US avoids a recession, it doesn’t mean a new equity bull market is about to begin. For stocks to break out, they need stronger economic growth. That would require the Fed to start cutting interest rates. Rate cuts boost stocks in several ways—they make bond yields less attractive, which prompts investors to move money into equities…and they are stimulative in the same way that rate hikes are restrictive—consumers and businesses increase loan-taking, spending and investment, which boosts demand…raising corporate profits…which supports higher stock prices.
Problem: The Fed is no longer willing to come to the stock market’s rescue. Fed Chairman Jerome Powell has made clear that he and his colleagues will keep interest rates elevated until inflation hits 2%, a sweet spot the Fed has deemed low enough for consumer comfort yet relaxed enough for the economy to flourish. But as I warned Bottom Line Personal readers in January, the pandemic has created a new economic environment in which demographic and geopolitical forces will keep inflation above 2% for the foreseeable future and present to the Fed a set of difficult choices, which ultimately could lead to a recession.
What investors should do: Stay defensive. The most likely scenario for stocks is a sideways pattern with an upward tilt and lots of volatility, so there is little downside to being cautious. If you have new capital to invest, cash is king. Short-term interest rates will remain high, so you can get a risk-free 5% or more return from short-term Treasuries or CDs.
For the rest of the year and beyond…
GDP: I am forecasting real GDP growth of about 2% in 2023 and 2024, supported by strong federal, state and local government spending and solid consumer spending, which I expect to grow at a solid 2.5% rate this year.
Unemployment: The red-hot job market should decelerate but still add an average 150,000 jobs a month for the rest of 2023. I expect unemployment to stay relatively low, perhaps reaching 4% by year-end 2023 and 4% to 4½% in 2024. Wage growth should be up 7% this year and 5% to 6% by year-end 2024.
Inflation: As measured by the CPI, inflation can moderate to 3½% or so by year-end 2023 and be near 3% by year-end 2024.
The market may have seen much of its gains for the year in a sharp first-quarter rally and now is somewhat overvalued from a historical perspective. I’m forecasting the S&P 500 will return near 15% by year-end 2023, and the Dow Jones Industrial Average around 11½%, including dividends. Although corporate earnings growth will enter a mild recession this year with 2%-to-3% losses for the S&P 500, companies are maintaining profit margins and increasing efficiencies. In 2024, earnings growth should rebound at 5% to 7%. Best stock sectors for the rest of 2023…
Health care, especially pharmaceuticals, which are benefitting from drugs to treat everything from Alzheimer’s disease to weight loss. This sector is viewed as defensive in a difficult market.
Consumer discretionary. Except for the auto industry, stocks for leisure, travel and high-end goods should benefit from strong consumer spending.
Foreign developed countries. After a decade-and-a-half of underperformance, stocks in Europe and Japan offer better valuations than comparable US stocks.
Sectors to avoid…
Utilities. Investors face less risk and better returns in money-market funds, CDs in FDIC-insured accounts, and short-term US Treasuries.
Financials, which will continue to be under pressure from banking and non-bank institution troubles.
I expect yields on 10-year US Treasuries, 3.81% in May, to stay in the 3.75%-to-4% range through 2023 and then dip back to 3% to 3.5% by year-end 2024. The total bond market should have slightly negative returns for 2023. Bonds remain in an ongoing bear market, which won’t end until the Fed makes significant short-term interest rate cuts. For seniors, the most attractive fixed-income options are US Treasuries, top-quality corporate bonds and municipal bonds, all held to maturity to ensure guaranteed return of capital.