Three themes for the second half of 2023

As investors approach the mid-year point for 2023, there are a few notable trends to highlight: First, the markets overall continue to be remain resilient. Despite last week's pullback, the S&P 500 is up over 13% year-to-date, albeit still largely driven by a handful of sectors and large-cap technology stocks, supported by enthusiasm around the emerging artificial intelligence (AI) sector. More recently, however, we had started to see some broadening of participation, with small-cap stocks and some cyclical sectors like industrials and materials rebounding.

Second, the Federal Reserve (and central banks globally) do not yet seem done with their rate-hiking cycles. The Fed has indicated up to two more rate hikes are likely, although it may be headed towards a pause in the back half of the year.

And third, the U.S. economy continues to defy calls for recession, with the Fed's own GDP-Now tracker calling for about a 2.0% growth rate in the second quarter.

So how may the economy, Fed, and markets fare as we head to the back half of 2023? We highlight three key trends below:

• The economy, and inflation, are likely to cool
• The Federal Reserve will pause its rate-hiking cycle, although rate cuts are not likely until 2024
• Markets may face some periods of volatility as the economy softens, but this will give investors an opportunity to position for a recovery period ahead

Theme 1. The economy and inflation are likely to cool

The U.S. economy may be heading towards below-trend growth?

The U.S. economy has defied expectations and ongoing calls for a recession, even as the Fed has raised rates aggressively over the past 16 months and as the yield curve has been inverted since last July. This is in large part due to the resilience of the labor market, which still boasts an unemployment rate of 3.7% - near multi-decade lows – and healthy wage growth of 4.3%.1?As we know, consumers are generally more comfortable spending when they are fully employed and feel secure in their jobs. And the strength we see in the labor market is also partly a result of a pandemic distortion – many left the labor force during this period, and certain industries still struggle to find workers, especially those in sectors that require in-person and frontline workers.

However, we are starting to see early signs that the labor market, and the economy, may be cooling. Some leading indicators of the labor market point to a pending softness, including rising jobless claims, lower quits rates, and falling job openings. In addition, leading economic activity indicators, like the ISM manufacturing and services indexes, and particularly the new orders components, are all moving lower. In fact, the manufacturing components are already well into contraction territory. And traditional U.S. leading economic indicators, including indexes from the Conference Board and OECD, have all moved south.?

The long and variable lags of the Fed's tightening campaign may be catching up with the economy, but it is also clear that this cycle will be unique. Ultimately, we may see more of a rolling recession – implying that some sectors may be heading into downturn, while others are stabilizing and rebounding. Housing, for example, seemed to have troughed earlier this year and now is perhaps stabilizing. Overall, this may lead to economic growth in the U.S. that falls to below trend, perhaps sub 1.0%, but we may not see the traditional two or more quarters of negative growth. And importantly, we still do not see the scope for a deep or prolonged economic downturn as we head to the back half of 2023.

Inflation will also likely continue to trend lower

Meanwhile, as economic growth cools, we also see the path for inflation to continue to move lower in the months ahead. The forward-looking indicators on inflation continue to trend lower, as measures like the ISM prices paid indexes, supply chain pressure metrics, and used car prices are all lower. The Federal Reserve would also like to see wage growth cool and services prices ease, which would give some relief to core inflation, although this becomes tougher as we head into summer traveling season and demand for leisure and hospitality services remains high. Nonetheless, as interest rates remain high, lending standards remain tight, and the economy potentially cools, our view is that headline inflation will likely head towards 3.0% by year-end, giving the Federal Reserve some room to step to the sidelines on rate hikes as well.

Theme 2. The Federal Reserve will likely pause its interest-rate hiking cycle in the second half of 2023

The Fed has continued to talk tough on battling inflation, as it likely should, given that headline inflation remains around 4.0%, and core inflation remains above 5.0%.1?The FOMC has indicated in its June projections that the peak fed funds rate may get to 5.6%, implying two more rate hikes from here. However, markets are pricing in one more hike at the July meeting, before pausing for the rest of the year.1?In our view, the Fed will raise rates in July, and then be highly data dependent, likely leaning towards a pause thereafter.?

If the Fed does move the sidelines in the second half of 2023, markets should welcome this reprieve from the rate-hiking cycle and may view it as one step closer to the start of rate cuts as well. In our view, rate cuts are unlikely this year, barring any shocks that would push the economy into a more severe recession. However, the Fed itself has indicated that rate cuts are likely in 2024, with its projections pointing to the fed funds rate moving lower by 1.0% next year. In our view, if inflation continues to moderate, the Fed may start to signal rate cuts by year-end or early next year, particularly as interest rates remain in very restrictive territory currently.?

Theme 3. Opportunities forming in both equities and bonds

The third theme for the back half of 2023 is the opportunities that are forming in both equity and bond markets for the 12-24 months ahead. While 2022 was a challenging year for investors, we are seeing early signs of a rebound, particularly in sectors that were hardest hit last year. While some form of an economic slowdown is possibly ahead of us, we believe last year's market sell-off captured some, or most, of this downturn. Markets may not be able to ignore a mild recession or economic downturn, but we think volatility ahead could be used as an opportunity to position ahead of a more sustainable recovery.

In our view, the gradual decline in inflation and shift in central bank policies suggest that a foundation of a new bull market may have already formed. In equities, we would look for broader participation, particularly as investors look towards 2024, which we think could bring lower inflation, lower interest rates, and better earnings trends. Leadership could include small-cap stocks, cyclical sectors like industrials, materials, consumer discretionary, and international equities – alongside AI and technology.

And finally, in bonds, we see a compelling opportunity forming to complement some positioning in short duration bonds and cash-like instruments with longer-duration bonds, particularly in the investment grade space. Keep in mind that the peak in Treasury yields typically occurs one to two months prior to the peak in fed funds rate, which could imply peak yields are likely in the weeks ahead. This would present an opportunity for longer-duration assets, as investors could capture better yields, but also have the potential for price appreciation, as the Fed pauses and ultimately pivots lower.

Read the full Weekly Market Wrap here: https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/stock-market-weekly-update