As we approach the second half of 2023, markets are pricing a benign path forward. Implied equity volatility is the lowest since the onset of the pandemic, and the S&P 500 is up 20% from October’s low. The calm before the storm? Or the end of the worst recession that never was?

In our view, for equity markets to rally further, investors will at least need to believe in the following three narratives:

  • The Federal Reserve won’t increase interest rates any more than the two hikes implied by the latest “dot plot.” Lower headline and core inflation, alongside challenges faced by US regional banks, has boosted market conviction that the Fed is close to the end of its hiking cycle. From here, this conviction could only go higher if disinflationary forces strengthen, or if investors believe that political considerations will lead the Fed to allow inflation to run above its target for an extended period.
  • The widely predicted US recession is canceled. Economic growth and corporate earnings have so far proven sturdier than expected, as the drawdown of excess savings, resilient asset prices, and a strong labor market have supported con­sumer spending. Confidence that a recession can be avoided could increase if real income growth continues to improve, companies start restocking inven­tories, and the labor market remains robust.
  • The rally in artificial intelligence has been justified, and a combination of enthusi­asm and FOMO (“fear of missing out”) helps keep it going. The “surging seven” US mega-cap growth stocks have risen by an average of 86% this year amid optimism about the impact of AI on their long-term prospects. These seven stocks alone account for 80% of the gains in the S&P 500 so far this year, so a positive market outlook from here is also contingent on these stocks holding onto or extending their gains.

Each of these individual narratives has merit. Although the Fed has indicated it intends to resume rate increases, the acknowledgment that the pause was more of a “skip” shows the deep divisions on the committee that needed to be bridged to reach a consensus on further hikes. Furthermore, we think it could get harder to restart hikes, particularly as the US presidential election season approaches. We think consumer data will continue to surprise positively in the months ahead (even if overall economic growth does continue to slow). And, while predicting short-term moves in AI stocks is speculative, we think the technology will prove transformative in the long run.

But these narratives don’t coexist comfortably. For example, if consumer spending, the labor market, or the stock market proves “too resilient,” investors could start to worry that the Fed will need to hike further. In turn, fears of higher rates, one or two disappointing economic numbers, or a shift in equity market sentiment could quickly unravel optimism about AI or consumer resilience. For this positive overall narrative to hold together, therefore, an “immaculate disinflation” is almost a prerequisite.

Investors face a balancing act. There is a path higher for stocks, but it’s a narrow one. After a strong run, the upside to stocks is now limited. And increas­ingly bullish equity market sentiment speaks against chasing the S&P 500 higher.

We therefore continue to prefer fixed income to equities and have a preference for quality bonds. Thematically, we focus on earning income (such as quality dividend-paying equities across traditional and sustainable strategies), identifying cheaper parts of the market that have lagged in the rally (like emerging markets, defensives, and value), and building more resilient diversified portfolios with alternatives.

Read more in our latest Monthly Letter, “ Balancing act,” and in our newly published 2H Outlook report, or watch a short video on the main themes here.