Predicting the Past

Market Commentary | Q2 2023 

Hindsight brings clarity to patterns and connections between events, and it often leads to the belief that these patterns could have been predicted ahead of time. After all, once you know the outcome, a sequence of events can feel like it was foreseeable. As humans, we naturally discount the unpredictability of past moments. 

Economists and pundits have been predicting a recession since March of 2022, often asserting that it was obvious what would happen next.[1] As they saw interest rates increasing rapidly, inflation far above Fed targets, and an inverted yield curve – a common recession indicator – they assumed a recession was imminent.

Yet as we cross the midpoint of 2023, the global economy has remained on solid footing and both stock and bond markets have provided investors with strong returns over the past six months. The S&P 500 has gained +15.9%, the EAFE index that measures international stocks has gained +10.7%, and the Bloomberg US Bond Index has gained +2.8%. Ignoring the doom and gloom predictions, and opting to remain invested has benefitted portfolios positioned for growth as the market rebounded. Looking ahead to the second half of the year, the question is whether global economies can maintain their defiant resilience, or if predictions about a looming recession were merely early. 

Often the challenge of prediction is not in determining what will happen, but rather when it will happen. It’s easy to predict that the US economy will slip into a recession at some point – after all, the US economy has experienced a recession every 5 years on average since 1950.[2] Recessions are a normal and recurring part of the economic cycle, not dissimilar to the importance of winter in the natural cycle of seasons. Rather than embracing the belief that we can entirely avoid a recession, much like we can’t skip a season, it makes more sense to examine which factors have helped the economy remain resilient enough to extend the growth phase of the cycle. 

First, energy prices have dropped far more than expected after spiking higher last year when Russia weaponized its energy supplies as part of its strategy in Ukraine. This downward trend in natural gas prices has benefited Europe in particular, avoiding the worst-case predictions as the EU was able to replace Russian gas supplies more easily than expected, and mild weather eased demand. Energy-intensive businesses have restarted operations and consumers are benefitting from lower energy costs compared to a year ago. In the short term, this has been positive for markets, but falling prices are also a symptom of slowing economic activity that could morph into a recession while central banks keep interest rates at elevated levels. 

Secondly, and perhaps more importantly, unemployment has remained low as the labor market has been less sensitive to interest rates than economists thought, at least so far. Consumers and companies have benefited from low-interest-rate loans that they locked-in over the past few years. Household savings also increased significantly during the pandemic, which supported continued spending. Despite being eroded by inflation, estimates suggest that these excess funds could be available to support personal spending at least into the fourth quarter of 2023.[3] At the national level, US GDP was revised upward to a +2.0% annualized rate in Q1 and is currently forecast to grow by +1.8% in Q2.[4] Even with GDP growth slowing over the past few quarters, this data doesn’t appear to signal an economy on the brink of a major recession.

The US economy appears to have successfully avoided ‘hard landing’ recession predictions, and while that should be applauded, it doesn’t mean there isn’t turbulence ahead. The latest inflation data measured by the CPE was released earlier this week and fell to 3.8% annualized rate, coming in slightly lower than expectations and providing a boost to markets.[5] Despite the downward trend of inflation, it remains significantly above the Fed’s 2% target. The Fed is faced with the difficult question of whether to continue an aggressive push to tame inflation or to be patient as global economies continue to normalize post-pandemic, the path forward is not obvious. 

If consumer demand and labor markets remain solid, then we expect further interest rate hikes in the coming months. If markets continue to dismiss the Fed’s hawkish guidance, it may embolden central bankers to test the upper bound on rates. This would likely push stock prices downward as higher-for-longer scenarios are priced into valuations. If the Fed pushes too far and a recession does arrive, then it may be forced to reduce interest rates slightly to provide relief to the economy, which would immediately push bond prices higher. Alternately, if the Fed can continue threading the needle of cooling inflation and a stable economy, then US stocks would be poised for continued growth as fears of inflation and higher rates diminish. 

When we look back on this period of economic history, it may be obvious where the Fed should have paused or pivoted, but in that prior moment, it would have been impossible to predict precisely what would happen. Similarly, hindsight can tempt investors into believing we can predict exactly what comes next, but the same reality remains true: the future is always unknowable. 

At North Berkeley, this is why we believe diversification is so valuable; it provides a balance of growth and protection, making your portfolio more resilient across a variety of future scenarios. Economist Dave Rosenberg recently summed up this balance in the following way, “You buy bonds to limit your risks and provide a buffer when the tough economic times come, and they always come. … Bonds are a ballast in the portfolio and the reason to own them is not the same reason as why you own stocks: stocks for their higher return potential, and bonds to preserve the capital when the tide turns.”[6]  

While we are pleased with the growth in the first half of the year, we know that stocks do not move in a straight line indefinitely, and volatility is an inevitable part of the cycle. The inherent unpredictability of the market, especially over the short-term, only strengthens our commitment to building resilient portfolios and prioritizing good process over bold predictions. 

Resources

[1] Economists Place 70% Chance for US Recession in 2023 Bloomberg

[2] History of Recessions in the United States The Balance 

[3] The Rise and Fall of Pandemic Excess Savings Federal Reserve Bank of San Francisco 

[4] Gross Domestic Product (Revised Estimate), First Quarter 2023 U.S. Department of Commerce 

[5] Key Fed inflation measure shows prices rose just 0.3% in May CNBC 

[6] Dave Rosenberg; excerpt from Early Morning with Dave. 6/26/2023.