Economic & Market Perspective: Midyear Outlook 2023
Through the first six months of 2023, equity markets made significant progress in erasing the losses suffered in 2022. The S&P 500® Index returned 8.7% during the second quarter to finish a surprisingly strong first half of 2023 up 16.9%. This occurred despite facing an additional three interest rate hikes of 0.25% each, with the prospect of more to come in July and September. Additional headwinds, such as persistent inflationary pressures, a robust job market and a looming threat of a recession, complicate the landscape for the financial markets and economy.
Looking ahead, Mutual of America anticipates that market volatility will remain elevated throughout 2023, as short-term data and policymakers’ comments continue to drive market sentiment. The key issues we’re closely monitoring include the U.S. Federal Reserve’s ability to manage inflation and avoid a recession, job market conditions, corporate earnings and the overall health of the financial sector.
Equity Markets Produce Strong First Half
In the first six months of the year, the major equity indexes were all highlighted by positive performances. The S&P 500 Index rose 16.9%, the Dow Jones Industrial Average showed a modest increase of 4.9%, and the Nasdaq composite displayed significant growth, jumping 32.3%. The latter’s return in the first half was its strongest since 1983. It is worth noting that, during this period, the Nasdaq outperformed the Dow by the widest margin since 2001, particularly due to its focus on technology-related companies. The Russell 1000® Growth Index outperformed the Russell 1000® Value Index by over 24%.
Thus far this year, the U.S. equity markets have been dominated by mega-cap growth stocks. The average year-to-date return, through June 30, on Amazon, Apple, Google, Meta, Microsoft, Netflix, Nvidia and Tesla, was a stunning 59%. It’s worth noting, however, that the average year-to-date return for the rest of the S&P 500 was just 3.7%. Apple’s market cap—which represents its total outstanding shares of stock multiplied by its price—is now the same as the entire Russell 2000® Small Cap Index. These eight companies represent the highest share of market cap on record, at 28%. Further, the percentage of stocks beating the S&P 500 on a trailing three-month basis was just 11%, surpassing the March 2000 low of 20%. Not surprisingly, the equal-weighted S&P 500 was only up 7.0% year to date. It is also interesting to note that the Dow return of 4.9% was driven entirely by Microsoft and Apple, which together make up 10% of the weight in that index.
Despite strong returns in both the first and second quarters, those returns have not completely made up for the losses from 2022. Over the last 18 months, the S&P 500 is down 4.3%, the Dow is down 2.3%, and the Nasdaq Composite is down 10.7%. However, in looking at returns since March 17, 2022, the day of the Fed’s first interest rate hike, the picture looks much different and much more even: the S&P 500 Index is up 3.0%, the Dow is up 2.5%, and the Nasdaq Composite is up 2.5%.
Bonds Continue to Show Strength
Despite a slight decline in bond prices in the second quarter, the bond market showed strength on a year-to-date basis through June, largely driven by decreasing interest rates starting in the latter part of 2022. The 10-year Treasury yield reached its peak at 4.23% last October. By the end of March, it had fallen to 3.47%, before moving back up by the end of June to 3.83%. Year to date, the 10-year Treasury generated a positive return of 1.7%, the 30-year Treasury yielded a return of 3.3%, the Bloomberg U.S. Corporate Bond Index rose 3.2%, and the Bloomberg U.S. Aggregate Index delivered a 2.1% return.
The persistently inverted yield curve continues to serve as a potential indicator of an impending economic slowdown. In 2022, the yield curve initially inverted on April 1, with the 2-year Treasury yielding more than the 10-year Treasury. Although the curve briefly returned to its normal shape, another inversion between the 2-year and 10-year Treasuries occurred in early July. Then, in late October, the yield on the short-term 3-month Treasury bill surpassed that of the 10-year Treasury. As 2022 drew to a close, the inversion intensified, and then, in the initial months of 2023, the spread widened further. Presently, the interest rates offered by 3-month Treasury bills are more than 1.45% higher than those provided by 10-year Treasury bonds.
The significance of an inverted yield curve lies in its reflection of how investors perceive the trajectory of the U.S. economy. If there is a prevailing belief in an upcoming slump or recession, investors tend to flock toward long-term U.S. bonds, causing the inversion. Notably, an inverted yield curve has preceded the 10 most recent recessions, underscoring its historical correlation with economic downturns.
Inflation Lower, but Still Persistent
Inflation continues to present an enduring challenge in the U.S., commanding the undivided attention of the Fed in its ongoing pursuit to curb its impact. The latest reports from two prominent inflation indicators consistently indicate levels surpassing the Fed’s average target of 2.0%, albeit with improvements observed since reaching their respective peaks.
Through May, the Bureau of Economic Analysis’ Core Personal Consumption Expenditures (PCE) Index, which is the Fed’s favored inflation indicator, and which excludes food and energy costs, declined approximately 1% since the start of the year. However, it still remains at an elevated level of 4.6%. The most widely recognized indicator, the Consumer Price Index (CPI), rose 3.0% year over year for June. The CPI measures the average price change for a fixed basket of consumer goods and services. One point worth noting is that the June CPI report marked the 28th consecutive month with inflation surpassing the Fed’s target rate of 2.0%.
Student Debt, Automobiles and Credit Cards
Millions of borrowers have been stuck in a state of uncertainty, eagerly awaiting the fulfillment of President Biden’s campaign promise for student debt cancellation. Finally, in August of last year, his administration unveiled plans for student loan forgiveness. These plans aimed to cancel up to $20,000 for eligible borrowers, totaling approximately $400 billion. However, the administration’s efforts were thwarted in June when the U.S. Supreme Court blocked the implementation of the student loan forgiveness program.
As a result, some 45 million student loan borrowers will have to restart payments on student loans after a three-and-a-half-year hiatus. On pause since March 13, 2020, federal student loan payments are scheduled to resume on October 1, 2023, with interest starting to accrue once again in September. According to data from Experian, student loan borrowers will start to make an average payment of $203 later this summer toward their student loan balances, assuming no further reductions in the average due to student loan forgiveness. Although this amount may be lower than typical car payments, it adds another financial obligation for many individuals already grappling with increased living expenses due to inflation.
Taking a closer look at data on nonstudent debt shows that borrowers are already struggling. The median cost of servicing this other debt has increased by 24% since the pandemic began, as a result of higher interest rates and larger balances on auto loans and credit cards. Delinquency rates by historical standards are still low, but they are on the rise. As of March, nearly 8% of borrowers were at least 60 days late on payments, up from 5% in July 2021. To compound the issue, these delinquencies primarily affect middle-aged borrowers who carry substantial loan balances and should ideally be focused on savings during their prime years.
Labor Market Remains Resilient
The labor market continues to exhibit remarkable resilience, which is a significant factor for the Fed to consider. Overall, the unemployment rate remained steady at 3.6%. Over the past 12 months, employers added more than two times as many jobs as they did in 2019, the year before the pandemic began.
In June, U.S. nonfarm payrolls rose by 209,000 jobs, which fell short of expectations and were more than 100,000 fewer than the 310,000 created the previous month. The cooler jobs report could potentially be viewed as a harbinger of slower growth. However, June’s number is still above the long-term historical average—from 1939 to 2023, nonfarm payrolls averaged 125,000 per month, according to Trading Economics.
More worrisome, average hourly earnings remained steady at 4.4%, consistent with recent trends. Wage inflation, caused by high labor demand, the retirement of baby boomers and historically low labor-participation rates, has given workers leverage when negotiating contracts. A few recent examples of workers who negotiated significant wage increases include dockworkers on the West Coast, FedEx pilots and Delta Air Lines pilots. Additionally, hotel workers in Southern California are striking for higher wages, and UPS is engaged in contract negotiations with the Teamsters Union over pay for drivers.
The Bureau of Labor Statistics’ Job Openings and Labor Turnover Survey (JOLTS) for May revealed that there were 9.8 million job openings nationwide, down from 10.1 million in April. This indicates that there are more job opportunities available than there are job seekers, underscoring the tightness of the labor market. The Fed’s objective is to prevent wage-price spiral inflation, where higher wages lead to increased costs for companies that may subsequently pass on the burden to consumers. Hence, it is crucial for the Fed to cautiously manage the pace of job market growth in order to curb inflation without causing a significant surge in the unemployment rate.
The Economy Is Slowing Down
In an attempt to address rising inflation in early 2022, the Fed embarked on a proactive path of raising interest rates beginning in March 2022. To date, a cumulative increase of five percentage points has been implemented, and the repercussions of 10 rate hikes are beginning to manifest in the economy. Nevertheless, it is essential to recognize that interest rate policy is a broad tool with prolonged and uneven effects. There are indications that the rate hikes are starting to impact specific sectors of the economy.
The housing market is one area where the influence is particularly noticeable, as higher mortgage rates are causing a slowdown. In 2022, the 30-year fixed mortgage rate commenced at 3.1% and reached a peak of 7.1% in November. Through June of 2023, the rate stood at 6.8%. Not surprisingly, June mortgage applications were down 4.4%. Housing affordability is at multidecade lows, hurt by home-price appreciation, higher mortgage rates and limited inventory.
Another significant economic indicator is the ISM Manufacturing Index, also known as the Purchasing Managers’ Index. While the initial reading in 2022 was 58.8, by June 2023, it had experienced a substantial decline, contracting by 12.8 points to 46.0. This decline, which signifies a reduction in ordering activity at the nation’s factories, marked the eighth month of contraction and the longest contraction trend since the Great Recession of 2008–09.
Commodity prices have also started to recede, indicating a potential economic slowdown. This marks a reversal from a year ago. As of June 30, 2023, the S&P GSCI commodity index was down 11.4% year to date, and prices of energy, grains and other raw materials have all declined.
Considering the recent upheaval in the banking sector, we anticipate certain immediate consequences, including increased regulations on small and regional banks, tightened lending standards and a decrease in the overall number of loans. Although these changes were not intended by the Fed, they are expected to significantly impact lending activity, which will ultimately have a dampening effect on the economy.
As predicted, Fed officials maintained the current rates during their June 14 meeting. It was the first “pause” since March of 2022. However, the markets are pricing in a 92.4% probability that the Fed will raise interest rates by 25 basis points to a range of 5.25%–5.5% on July 26, according to the CME FedWatch Tool. There is a 26.6% chance of another increase of the same size at the September meeting. The central bank is not expected to take its fed funds rate target back to around 5% until next year.
Equity Valuations Worth Watching
There has been a notable change in the equities landscape, shifting the focus from last year’s “multiple compression” narrative to concerns surrounding a potential slowdown in growth or even a growth recession for corporate earnings. As we start the second-quarter reporting season, analysts are expecting earnings in the S&P 500 to decline by 7.5%—this would represent the third consecutive quarterly earnings drop. One contributing factor to this earnings decline is the reduction in profit margins. Despite healthy revenue growth, rising costs have exerted pressure on margins, leading to a squeeze in profits. In fact, profit margins have decreased for the last seven quarters.
Adding to these concerns, the current price/earnings ratio for the S&P 500, as reported by FactSet, stands at approximately 18.9 times, surpassing the year’s initial value of 16.7 times and surpassing the 25-year historical average of 16.8 times. This suggests that stocks are currently not priced at a bargain. While multiples have expanded since the beginning of 2023, the market breadth, which indicates the number of stocks participating in the market rally, has been narrow. A mere eight stocks—namely Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia and Tesla—now account for a significant 28% of the weight in the S&P 500. To put it in perspective, these same stocks represented only 22% of the market capitalization at the start of this year.
Despite various challenges, such as the Federal Reserve’s rate hikes, inflationary pressures and the looming recession, equity markets have generally shown upward movement. Major equity indexes like the S&P 500, Dow Jones Industrial Average and Nasdaq have posted positive returns, with the Nasdaq having its best first-half performance since 1983. Mega-cap growth stocks, particularly in the technology sector, have led the way in driving the overall performance of the equity markets. However, the bond market recently presented a slightly different picture, with rising bond yields and falling prices, indicating a divergence from the synchronized movement with equities seen in the first quarter of this year.
Looking ahead, Mutual of America expects market volatility to remain elevated throughout 2023. Factors like inflation management, job market conditions, corporate earnings and the overall health of the financial sector will be closely monitored. While equity markets have shown strength, concerns over equity valuations, declining corporate earnings and a potential slowdown in growth are emerging. The housing market has been impacted by higher mortgage rates, and the manufacturing sector has contracted. Commodity prices have started to recede, indicating a potential economic slowdown, and changes in the banking sector may lead to tightened lending standards. These and other factors suggest that certain sectors of the economy are beginning to slow down. With all of this in mind, and amidst such uncertainty continuing in the months ahead, investors need to carefully assess their investment strategies.
Stephen Rich is the Chairman and CEO of Mutual of America Capital Management LLC.
Past performance is no guarantee of future results. The index returns discussed above are for illustrative purposes only and do not represent the performance of any investment or group of investments. Indexes are unmanaged and not subject to fees or expenses. The index returns above reflect the reinvestment of distributions. It is not possible to invest directly in an index.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Securities offered by Mutual of America Securities LLC, Member FINRA/SIPC. Insurance products are issued by Mutual of America Life Insurance Company.