The Recession We Did Not Have
If generals are always fighting the last war, analysts are typically buying the last rally or shorting the last downturn.
Going into the fourth quarter of last year, investor sentiment was overwhelmingly bearish on 2023. It’s hard to blame them. Economists were widely predicting a downturn in consumer spending and economic output thanks to an exhaustion of stimulus-supplied excess savings and the Federal Reserve’s unprecedented series of interest rate hikes.
In October of last year, Bloomberg News reported that its proprietary recession probability model indicated a 100 percent chance of a recession in the next twelve months. Bloomberg said this was a more reliable indicator than its survey of economists, which saw only a 60 percent probability of a recession. The Conference Board’s year-ahead recession probability metric was up to 96 percent in September and eventually climbed as high as 99 percent. The editor-in-chief of the Economist penned an essay declaring a global recession in 2023 was “inevitable.”
The economics team at Fannie Mae, one of the best in the business, thought the economy would experience negative growth in the fourth quarter of 2022 and tip into recession in the first quarter of this year. At its December meeting, the Federal Open Market Committee cut its projection for 2023 growth from 1.2 percent this year to just 0.5 percent, which many saw as likely indicating that a recession was looming.
It wasn’t just the egg-heads who saw a recession bearing down on the economy. The Economist/YouGov survey at the end of last summer showed 60 percent of Americans thought we were already in a recession; and among those who said we weren’t yet in a recession, 55 percent said we were either likely or very likely to be in one over the next six months.
“Coming into 2023, most investors seemed to have the same outlook for the year: a tough first half for U.S. equities, followed by a strong finish, with a U.S. recession beginning sooner rather than later,” Mike Wilson of Morgan Stanley wrote in a research note. Bank of America’s sell-side indicator, which tracks the recommended allocation to stocks by U.S. sell-side strategists, fell to 53 percent in December. “Bears (like us) worry unemployment in 2023 will be as shocking to main Street consumer sentiment as inflation in 2022,” wrote Chief Investment Strategist Michael Hartnett in December.
Gloom and Doom Paved Way to Boom
Contrary to expectations, the economy grew 2.6 percent in the fourth quarter of 2022 and two percent in the first quarter of this year. By almost all accounts, it continued to grow in the second quarter. The Atlanta Fed’s GDPNOW measure shows the economy appears to have grown at a 2.3 percent annual rate in the April through June period. Personal consumption expenditures rose 4.2 percent, including a six percent increase in spending on goods and a 3.2 percent increase in services spending, contributing 2.79 percentage points to first-quarter GDP.
GDPNow suggests that consumer spending has slowed in the second quarter, contributing less than one percent to GDP. Nonresidential fixed investment, however, is now seen as contributing around one percent to GDP, up from almost nothing in the first quarter. Residential investment appears to no longer be a drag on GDP and may make a positive contribution for the first time in two years. Change in private inventories also appears to have gone from a minus to a plus for GDP.
The stock market’s returns were equally as impressive and contrary to expectations. The S&P 500 rose 15.9 percent in the first half of the year and saw a 16.9 percent total return, the best showing since 2019. According to Bank of America, this was the 12th best first half for the index going back to 1928 and far above the average return of 3.6 for the first six months of the year.
Traders work on the floor of the New York Stock Exchange during morning trading on July 6, 2023, in New York City. (Michael M. Santiago/Getty Images)
It was not just stocks. With the exception of commodities, all major asset classes rallied in the first half of the year. Bitcoin soared 83 percent. Gold glimmered up 6 percent. Long-term Treasuries rose 3.6 percent. Investment grade corporate bonds rose 3.2 percent. International stocks rose 9.9 percent in U.S. dollar terms. Cash returned 2.3 percent.
This performance was all the more impressive because Wall Street continued to underestimate the strength of the labor market and inflation throughout the first half of the year. In fact, June marked the end of one of the longest ever streaks—14 consecutive months—of payrolls exceeding expectations. Good news for the economy was widely expected to be bad news for stocks, but the stock market just did not comply.
Is It Over?
Naturally, many are wondering if the rally of 2023 is over. If you buy now, will you be buying the last rally only to discover the market is headed down? The economy does appear to be slowing down going into the back half of the year. Investors will be listening warily to quarterly results beginning this week for signals of economic sluggishness and earnings slumps. The Fed still appears to be hawkish, signaling that two more rate hikes are likely coming this year and no cuts will come until perhaps the owl of Minerva takes flight at the end of next year.
Stephen Suttmeier at Bank of America, however, points out that there are plenty of historical reasons to believe stocks will continue to perform well in the second half of 2023.
- After an above average first half, the S&P 500 tends to be stronger in the second half. It is up 77 percent of the time with an average return of 6.5 percent.
- The S&P has rallied more than 10 percent in the first half of the year just 28 times going back to 1928. After such a gain, the index has achieved another 10 percent or greater rally in the second half of the year 46 percent of the time. The only down year after a first half gain of 10 percent or more was 1929, which means the market has been up for the full-year 96 percent of the time following a 10 percent first half gain.
- The S&P is up 20 percent or more for the year 68 percent of the time after a 10 percent first half rally.
- When the S&P has an above average first half gain following a down year, it is up 86 percent of the time in the second half and 100 percent of the time for the entire year.
Perhaps the most reassuring indicator of all is that Wall Street remains overwhelmingly bearish. The Bank of America sell-side indicator climbed after the June rally in stocks but remains deep in bearish territory, with an average stock allocation of just 52.9 percent. This is a reliable contrary indicator, indicating stocks will rise when strategists are extremely bearish. Sentiment is now near a six-year low, and the indicator has remained within two percent points of a contrarian buy signal for the past year. According to the bank’s analysts, when the indicator is this low or lower, the S&P returns were positive 95 percent of the time (compared to 81 percent overall).