Markets, US Economy Expect more challenges for stocks in the second half

But with both global and US stocks more than 20% above their October 2022 lows and a more challenging second-half outlook, we believe investors should position for more lackluster stock market performance through the remainder of the year:

Equity pricing looks at odds with slowing growth and stickier inflation. Stock markets appear to be pricing a near-perfect economic outcome, in which a rapid fall in inflation allows the Fed to end its tightening cycle, while US growth remains resilient.

We see risks of persistent core inflation to mean US rates could move higher and stay at these levels for longer. While the Federal Reserve left rates unchanged at its June meeting, the projections of top officials pointed to a further 50 basis points of tightening. US core inflation—which excludes food and energy prices—remained stubbornly high, at 5.3% in May from 5.5%in April. And the overall data from the US labor market suggest enduring tightness.

What’s more, fears of higher rates, a few disappointing economic numbers, or a shift in equity market sentiment could quickly unravel optimism about US growth resilience and its underpinnings, like consumer resilience.

Artificial intelligence (AI) stocks' performance could consolidate after exceptional gains. Investor enthusiasm over the potential of artificial intelligence to boost the technology sector has also supported year-to-date equity gains. The NYSE FANG+ index, which tracks the top 10 most traded tech stocks, has rallied more than 75% this year.

But, there were signs in June that mega-cap AI equities are consolidating (and that the rally is broadening to laggards). The equal-weighted S&P 500 Index outperformed the cap-weighted benchmark in June, though it still lagged for the quarter as a whole.

Valuations look more appealing in bonds. US equities (the MSCI USA Index) ended June trading at a 12-month forward price/earnings multiple of 19.3 times. At a 19% premium to its average over the past 15 years, elevated valuations would typically be consistent with expanding economic growth and higher expected corporate profits.

But with global interest rates potentially staying higher for longer, we see limited room for global equity valuations to improve in the second half. We also see earnings at risk as economic growth decelerates and profit margins trend lower.

By contrast, yields on high grade government debt look appealing after their June increases to reflect tighter borrowing costs. The yield on 2-year US Treasuries rose from 4.43% at the start of the month—and 4.06% at the start of the second quarter—to 4.90% at the end. And the yield on 10-year US Treasuries climbed from 3.66% at the start of June (3.49% at the start of the quarter) to 3.82% at the end.

Looking at current valuations and the potential macro scenarios from here, we see a better risk-reward balance in bonds than in equities for the remainder of 2023. We outline three potential investment ideas to navigate a more challenging second half.

First, investors should consider buying quality bonds. More-resilient-than-expected economic data have boosted yields in recent weeks, offering an opportunity to lock in elevated yields as the Fed engages in a balancing act between price stability, full employment, and financial stability. We see opportunities in high grade (government), investment grade, and sustainable bonds, and select senior financial debt. Actively managed fixed income strategies can help investors take advantage of the breadth of opportunity.

Second, we see pockets of opportunity in lagging segments of the equity market. Concentrated gains and lofty valuations among some of the best performers may allow laggard sectors to gain in the second half. Investors should protect their holdings through capital preservation strategies and rebalance into the laggards, like emerging markets, defensives, and value.

Third, we see potential for real assets to rally. The Fed could be willing to let inflation stay modestly above target for an extended period. If the delicate balance of financial and price stability tips over into fears that the central bank is risking inflation expectations running out of control, we think allocations to infrastructure, commodities, and select core real estate could help with long-term inflation mitigation and provide additional portfolio diversification and income.

Main contributors - Solita Marcelli, Mark Haefele, Christopher Swann, Jon Gordon, Matthew Carter

Content is a product of the Chief Investment Office (CIO).

Original report - Expect more challenges for stocks in the second half, 3 July 2023.