Quarterly market outlook - second quarter 2023

Asset class performance

Looking back at the 1st quarter

2023 started strong on signs the pressure to global growth might not be as bad as previously feared. But market volatility reappeared as investors weighed the potential economic impact of higher inflation and financial sector concerns, highlighting the value of portfolio diversification. Diversification does not ensure a profit or protect against loss in a declining market.

A rate-hiking pause draws nearer

Inflation concerns flared on signals prices may be trending downward slower than previously expected, which sent rates higher initially. The Federal Reserve hiked interest rates two more times in the quarter — though at a slowing pace — to help prevent elevated inflation from becoming a long-term drag on growth. Price pressures continued easing overall, and interest rates finished Q1 lower than where they started. We may not have seen the final rate hike, but updated Fed projections indicate a pause has drawn nearer, which could provide stronger footing for portfolios.

Financial sector concerns weigh on growth expectations

Turmoil surrounding U.S. regional banks, such as Silicon Valley Bank, and some larger, more global peers triggered uncertainty about the health of the banking industry. These pockets of financial sector distress caused new concerns for the economic outlook, with lending conditions likely to tighten. It may take time before the full impact of the recent banking-related crisis is known. But swift action from key authorities to provide stability, as well as the strength of banks more broadly, boosted confidence and reduced concerns as Q1 ended.

Leadership rotates, but markets remain resilient

Brighter growth expectations supported more economically sensitive segments of the markets in Q1 until inflation- and bank-related concerns rotated markets into a more defensive tone. In the end, all recommended asset classes ended the quarter higher. U.S. and international large-cap stocks led equities, while U.S. small-cap stocks lagged. Strong returns from growth-oriented equities, such as technology stocks, helped overcome weakness within financials and energy. Bond values rose as yields fell, offering a buffer against stock market volatility.

Action for investors

Markets are likely to be sensitive to additional news on the banking system, the path of inflation and monetary policy expectations. Work with your financial advisor to identify opportunities to add quality investments at lower prices, potentially enhancing your portfolio's diversification.

U.S. senior loan officers survey indicates tightening lending standards

Economic outlook

While the economy remained resilient in Q1 and the labor market showed ongoing strength, there may be signs of softening in the quarter ahead.

Higher interest rates and inflation weigh on households and corporate earnings

The Federal Reserve raised interest rates twice in Q1, bringing the federal funds rate to around 5%, its highest level since 2007. These higher interest rates increase the cost of borrowing for consumers and corporations, putting downward pressure on demand broadly. As a result, consumer confidence has moderated, and corporate earnings growth has been revised lower. For 2023, S&P 500 earnings growth is now expected to be around 1%, well below the 10% growth estimate expected mid-2022.

Banking sector turmoil may have ripple effects

While the recent volatility in the banking sector has stabilized, there may be longer-term impacts to economic activity. These may come in the form of banks tightening their lending standards and an increase in regulations focused on regional banks. As banks pull back on potential loans, corporate and consumer spending may moderate as well. Perhaps the silver lining is that tighter credit availability may also move inflation marginally lower, which could support a pause in the Fed’s interest rate hiking campaign.

We still anticipate a mild recession in 2023

In our view, a mild economic downturn remains likely and may begin sometime in the second half of 2023. We would expect to see consumption fall and the labor market to soften, although more modestly than in past recessions, with the unemployment rate perhaps remaining below 5%. We continue to see inflation moderating, with core inflation heading toward 3% by year-end. In this backdrop, the Fed is likely to pause hiking interest rates by mid-2023, which historically has been beneficial for both stock and bond markets. Past performance is not a guarantee of what will happen in the future.

Action for investors

While volatility may increase as an economic downturn emerges, markets are also forward-looking and can start to recover months ahead of a recession’s end. We recommend investors use pullbacks to diversify, rebalance and add quality investments to portfolios, according to their personal financial goals, ahead of a potentially more sustainable recovery.

A Fed pause can help stabilize yields and valuations

Equity outlook

Markets wrapped up a volatile but positive quarter as strength in tech offset weakness in banks. Uncertainties remain, and the path to recovery could be bumpy in the short term. But we think further moderation in inflation and a likely Federal Reserve interest rate pause by early summer can support a positive outlook for the remainder of 2023.

Volatility to stay elevated as growth slows

The economy started Q1 on solid footing, but we expect some softness ahead as the effects of monetary tightening filter through. Historically, it has taken 12-18 months for Fed hikes to impact demand and employment, and we are now in that time frame. While we anticipate a modest recession, we don’t expect a deep or prolonged downturn given the solid consumer finances and labor market dynamics. We believe a rebound could materialize in the second half of the year.

Stocks can start looking through the valley

As the economy slows, earnings will likely continue to be under some pressure. But last year’s decline in valuations potentially discounts some of the challenges. The current bear market started about 15 months ago. For perspective, the average bear since 1945 has lasted about 13 months. Though emerging bull markets don’t follow a timetable, stocks tend to move ahead of the economy and can bottom before economic data and headlines improve.

3 reasons mid-October could have marked the bottom

1. Even with lingering price pressures, we’re seeing a trend of disinflation. The path lower is unlikely to be a straight line and will require the labor market tightness to ease. But even with historic low unemployment, wage pressures have started to moderate.
2. After hiking rates aggressively over the past 12 months, the Fed is nearing the end of its tightening campaign. A Fed pause has historically been a catalyst for improved equity performance. Past performance is not a guarantee of future results.
3. S&P 500 earnings estimates have been cut to about 1% from about 10% a year ago. In our view, this better reflects the expected growth slowdown.

Action for investors

We recommend a neutral allocation to all equity asset classes. We favor increased allocations within health care and consumer discretionary and reduced allocations to utilities and communication services. Consider dollar-cost averaging to take advantage of the volatility and position portfolios for a more sustainable rebound.

A Fed pause has been positive for bond returns

Fixed income outlook

Government bond yields moved sharply lower in Q1 as the banking crisis unfolded, and investors flocked to safe-haven assets such as Treasury bonds. We would expect yields to stabilize and move somewhat higher in Q2, although the peak in yields for this cycle may be behind us.

A Fed pause is likely on the horizon

We would expect the Federal Reserve to pause raising interest rates in mid-2023, especially as economic growth softens and inflation continues to moderate. This would also likely cap an upward move in Treasury yields. Although markets are forecasting multiple rate cuts in 2023, we would not expect the Fed to pivot to lower rates unless inflation was closer to its 2% target or the economy was materially weaker. Inflation is still elevated, and the economy and labor market continue to show signs of resilience. However, the Fed could signal rate cuts toward year-end, as inflation potentially heads toward 3%.

A pause in rate hikes has favored bond returns

A Fed pause in interest rate hikes has historically been favorable for bond market returns. Since 1984, the average return for investment-grade bonds from a Fed pause to its first-rate cut is about 7%. Notably, in Q1, investment-grade bonds were up about 4%, as yields moved lower late in the quarter and investors sought safe-haven assets during the banking uncertainty. We would expect bonds to continue to offer this diversification benefit in the months ahead, especially during periods of equity market volatility.

Opportunities may be forming for longer-duration bonds

In Q1, investors continued to seek higher-yielding investments in liquid assets, including CDs, money market funds and short-term Treasury bonds. But we see opportunities forming to complement these potentially with longer-duration bonds, particularly in the investment-grade space. These bonds not only lock in yields for longer, but also have the opportunity for price appreciation, especially if the Fed does pause and, over time, move interest rates lower.

Action for investors

We see opportunities forming to complement shorter-duration bonds and CDs with longer-duration bonds, especially in the investment-grade space. We recommend working with a financial advisor to ensure your portfolio has adequate fixed-income diversification to meet your financial goals.

Global growth expected to slow before rebounding in 2024

International outlook

Global growth could stay lackluster this year. But China’s reopening, a potentially softening U.S. dollar and still-attractive valuations suggest international diversification could benefit portfolios again this year.

Europe dodges recession, but risks remain

Confidence in Europe has started to recover as an unseasonably warm winter helped avert a much-feared energy crisis. Natural gas prices shot up when Russia cut off its natural gas supply to the region, but they’ve now returned to where they were before the Ukraine invasion. With the help of a strong labor market, the economy grew in Q1 despite expectations for a contraction. Downside risks remain as the rise in borrowing costs likely pressures demand.

China’s reopening provides a boost

After battling a COVID-19 resurgence, China pivoted away from its zero-COVID policy in Q1. The reopening has so far led to a pickup in factory activity and should release pent-up consumer demand in the coming months. At the same time, the government continues to support growth. As a result, China is the only major country where growth is expected to accelerate from last year.

The global fight against inflation continues

Eurozone inflation appears to have peaked, but core inflation — which excludes food and energy — remains sticky and is higher than in the U.S. Because of this, the European central bank might stop hiking rates after the Federal Reserve does. With the difference between U.S. and European policy rates likely to narrow, the U.S. dollar could weaken, boosting international returns.

International valuations are not stretched, despite recent rally

International equities have outperformed U.S. equities over the past six months and one year. But despite the rally, international equities still trade at a near-record discount relative to U.S. equities. This suggests there is more room for global indexes to make up some lost ground over the past decade.

Action for investors

Balanced diversification across a variety of international asset classes can benefit a portfolio. We recommend neutral allocations to international asset classes, which will help keep your portfolio aligned to your goal.

Despite High Debt, Markets Have Quickly Moved Past Debt Ceiling Drama

Debt ceiling showdown: A temporary headline risk

With the recent bank crisis demonstrating the impacts of a financial shock to the system, we suspect policymakers will opt to avoid adding a government default to the mix. That said, we have little faith in policymakers' willingness to pursue an early, quiet compromise. We believe a deal will ultimately be reached to raise the debt ceiling and avoid default, but not before standoffs and political theater add some anxiety for financial markets. Importantly, we think that anxiety will prove temporary, with markets turning the sights back toward the economy and corporate fundamentals.

Drama, not default

This year, likely sometime this summer, lawmakers will need to raise the U.S. debt ceiling, an action that will require some form of bipartisan agreement. Given the deep party divides surrounding the budget, we doubt such an agreement will come without political theatrics, though we do believe a deal (perhaps at the 11th hour) will ultimately be reached as both sides of the aisle recognize that a default on U.S. government debt is not an acceptable outcome.

We suspect a compromise to raise the debt ceiling will be accompanied by a modest cut to future discretionary spending as well as potentially small, targeted increases on certain taxes. While this debt limit increase simply kicks the can down the road, we expect this outcome because: 1) it's the most viable move for now given larger budget issues cannot be solved this year, and 2) lawmakers should want to avoid adding a fiscal crisis to an already softening economy.

At more than $31 trillion, federal debt as a percentage of GDP has risen to a level last seen after World War II. The resiliency and vibrancy of the U.S. economy will enable the U.S. government to carry an elevated debt load with manageable financing costs (interest rates) for some time to come – but not forever. Last year, federal revenue only covered about 80% of spending, requiring deficits financing for the remainder. Eventually more difficult budget decisions will be required, including a combination of taxes and adjustments to both discretionary and non-discretionary (including Medicare, Medicaid, Social Security) spending.

Markets tend to move on quickly

Debt ceiling adjustments are common, with Congress having done so 78 times since 1960, including raising it twice in 2021 alone. This frequency means markets largely look past routine debt limit changes, though contentious political standoffs over the debt ceiling in 2011 and 2013 spurred temporary adverse reactions as the former was accompanied by the downgrade of the U.S. credit rating and the latter saw a more-than-two-week government shutdown. Brinkmanship tactics do pose a risk, but we think the more likely outcome will be some short-term volatility in both stocks and bonds as any potential deadline draws closer in the absence of a deal, with markets quickly shifting back to focus on fundamentals, not Washington.

Action for investors

Past debt ceiling showdowns have been short-lived in terms of market volatility. Even following the 2011 episode, equities rebounded shortly after and Treasury bonds rallied*. We would view any debt-ceiling weakness as temporary and we'd recommend adding to long-term positions on any such Washington-driven pullbacks.

Strategic asset allocation guidance

Our strategic asset allocation represents our view of balanced diversification for the fixed-income and equity portions of a well-diversified portfolio, based on our outlook for the economy and markets over the next 30 years. The exact weightings (neutral weights) to each asset class depend on the broad allocation to equity and fixed-income investments that most closely aligns with your comfort with risk and financial goals.

Diversification does not ensure a profit or protect against loss in a declining market.

Opportunistic asset allocation guidance

Our opportunistic asset allocation represents our timely investment advice based on current market conditions and our outlook over the next one to three years. We believe incorporating this guidance into a well-diversified portfolio may enhance your potential for greater returns without taking on unintentional risk.

Visit edwardjones.com for a discussion of portfolio performance.

Investment performance benchmarks

It’s natural to compare your portfolio’s performance to market performance benchmarks, but it’s important to put this information in the right context and understand the mix of investments you own. Talk with your financial advisor about any next steps for your portfolio to help you stay on track toward your long-term goals.

Asset class performance

U.S. equity sector performance

^{Source: Morningstar Direct, 3/31/2023. Cash represented by the Bloomberg US Treasury Bellwethers 3-Month index. U.S. investment-grade bonds represented by the Bloomberg US Aggregate index. U.S. high-yield bonds represented by the Bloomberg US HY 2% Issuer cap index. International bonds represented by the Bloomberg Global Aggregate Ex USD hedged index. International high-yield bonds represented by the Bloomberg Emerging Market USD Aggregate Index. U.S. large-cap stocks represented by the S&P 500 Index. Developed international large-cap stocks represented by the MSCI EAFE index. U.S. mid-cap stocks represented by the Russell Mid-cap index. U.S. small-cap stocks represented by the Russell 2000 Index. International small- and mid-cap stocks represented by the MSCI EAFE SMID index. Emerging markets represented by the MSCI EM index. All performance data reported as total return. An index is unmanaged and is not available for direct investment. Performance does not include payment of any expenses, fees, or sales charges, which would lower the performance results. The value of investments fluctuates, and investors can lose some or all of their principal. Past performance does not guarantee future results.}