Recession? Not So Fast

June 2, 2023

By Ellen Hazen, CFA®, Chief Market Strategist

May Takeaways:

  • Second quarter earnings season wrapped up with earnings underperforming revenue again. S&P500 companies in aggregate reported revenue growth of 4.2% and earnings decline of 3.6%. This is the fifth consecutive quarter of negative operating leverage, as companies are unable to fully pass through higher input costs
  • Earnings estimates for 2023 continue to decline. At the beginning of the year, Wall Street analysts expected S&P500 companies to grow earnings by 2%; now, they expect a 2% decline
  • The market increase continued to be driven by a very small handful of stocks, reflecting weak breadth. During May, the large-capitalization S&P500 appreciated by 0.4%, while the small-capitalization Russell 2000 index declined by 0.9%. During May, the five largest companies in the S&P500 appreciated by an average of 15.4% while the median stock declined by -4.6%; this continues the recent trend of a very narrow market. On a year-to-date basis, the S&P500 is +9.6%, while the median S&P500 stock is down -1.8%. Only 118, or under one-fourth, of S&P500 stocks have outperformed the S&P500’s 9.6% year-to-date return
  • Treasury yields rose during May and the curve inverted more steeply. The one-month T-bill climbed by nearly 100 bps to 5.25% as the Fed raised rates; the ten-year T-bill climbed by only about 20 bps to 3.65%. Corporate bond spreads widened modestly, leading to a slight negative return (-0.90%) for the broad Bloomberg Intermediate Government/Credit Index
  • Economic reports were generally positive: Jobs continue to be very strong, with unemployment back down to 3.4% in May; rose to 3.7% in June. GDP for Q1 was revised upward to 1.3%. Inflation continued its steady decline from the peak in June of 2022; April CPI of 4.9% was down from March at 5.0%. April PCE of 4.7% was a slight increase from 4.6% in March
  • The Federal Reserve Bank of Atlanta’s GDPNow indicator suggests that Q2 GDP will be 1.9%, up from 1.3% reported for Q1
  • The debt ceiling appears to be resolved, with a suspension having passed both the House and the Senate as we write

What We Are Watching in June

  • May jobs were reported on June 2; this was a very strong report, with 339,000 new jobs created in the month
  • The Consumer Price Index (CPI) will be reported on June 13, and the Personal Consumption Expenditure (PCE, and the Fed’s preferred measure) will be reported on June 30. These are both likely to continue to decline, although we believe that the PCE is unlikely to reach the Fed’s 2% target within the next several months, which leads us to anticipate continued Fed rate increases
  • Various Fed speakers have communicated a range of forecasts and opinions, with some seeking a pause or a skip in the interest rate increase path, and others seeking further increases

Fewer than one-fourth of S&P500 stocks have outperformed the S&P500 index year-to-date


Investors and pundits have been forecasting a recession in 2023 for months. If a recession occurs, some say that it will be the most-forecasted recession ever. We have been consistently pointing out that the data is mixed. Some tried-and-true indicators, like the Purchasing Managers’ Index (PMI) which dipped below 50 in October 2022, and the yield curve, which inverted in June 2022, have been flashing red for months. Others, such as the unemployment rate, which remains at a multi-decade low, and credit spreads, which remain benign, presage continued economic stability. While we agree with the bond market that GDP is decelerating, we do not anticipate a severe recession in 2023.

Services PMI vs. Manufacturing PMI

The manufacturing PMI has a much longer history than the services PMI; the manufacturing index dates back to 1948 while the services index only started in 1997. Many analyses use the longer-dated manufacturing index to predict economic activity, and recent negative manufacturing data underpins some recession forecasts. Yet, over the past several decades, services have become an increasingly larger part of the US economy. You can see in the chart below that while the manufacturing PMI dipped into contractionary territory (i.e., below 50) in October 2022 as mentioned above, the services index has generally remained above 50 since the economy re-opened. Yes, the services index has slowed as the economy has slowed. But measures above 50 are expansionary, and services are a larger part of the economy than manufacturing.

Strength of US Consumer

Because the consumer is two-thirds of the US economy, we keep a sharp eye on various measures of consumers’ health. In particular, why hasn’t the consumer significantly weakened in response to the Fed’s tighter monetary policy and higher interest rates? The answer has three parts: excess savings, a strong jobs market, and a fairly interest rate-insensitive borrowing profile.

Although the consumer is slowly spending down the excess savings amassed during the acute stage of the COVID pandemic (due to economic shutdowns, when consumers spent less money, and to government checks), in aggregate the consumer still has approximately 7% of annual spend above the pre-pandemic levels. This varies by income quintile; the lowest income quintile of households has spent down nearly all of their excess savings, while the other four quintiles still have just over 7%. In our view, this will continue to support consumer spending for the rest of 2023 and into 2024.

The jobs market remains very strong, with only 3.7% unemployment and over 10 million job listings per the recent Job Openings and Labor Turnover Survey (JOLTS).  Labor force participation has returned to or near pre-COVID levels for all age cohorts except 55+, who are historically unlikely to return to the labor market in full force. Thus, new labor supply to fill all these jobs seems unlikely to emerge absent a change in immigration policy. As a result, we expect the labor market to remain fairly strong for the near-to-intermediate term.

The consumer in aggregate is only modestly sensitive to the level of interest rates. For example, it is much less interest-rate sensitive than in 2007. In 2007, approximately 30% of all consumer debt was variable rate borrowing. This includes credit cards, home equity lines of credit, and adjustable-rate mortgages, among others. When interest rates rose, household debt payments increased in tandem, burdening households with higher interest expense. Consumers spent less as a result, which slowed the economy. Today, only 15% of consumer debt is variable rate. This is in part because so many households refinanced their mortgages into fixed-rate mortgages at decades-low rates in 2021. Thus, since the Fed started to raise interest rates a year ago, the impact on consumer expenses is much smaller than we have seen in prior cycles.

All in all, while we see economic activity slowing, given the strong consumer and the strong labor market, we think a severe recession is unlikely, and even a mild recession is not a sure thing in the near future.

A Word on AI

The increased capabilities of artificial intelligence have thrust it into mainstream investment culture. Large Language Models, such as ChatGPT-4 or Google’s BERT, are now widely available to the public. Companies are also actively developing their AI capabilities. The number of companies mentioning AI on their first quarter earnings conference calls has commensurately increased.

Will AI transform corporations? Yes, but likely not as fast as people currently expect. Like the Internet in the late 1990s, AI will be transformative, but will take longer to achieve than initially thought. Analyses suggest that approximately 5-7% of jobs may be at near-term risk of substitution by AI; however, another 15-20% of jobs will benefit from efficiencies that AI can bring to their daily work. These substitutions will take time. All-in, companies expect that over the long term, they may save 5-10% of costs as AI increases corporate productivity. A (very brief) list of jobs most at risk from AI include customer service reps, clerks, secretaries/assistants, and loan interviewers, while a (also very brief) list of jobs likely to benefit from AI augmentation include sales reps, teachers, coders, accountants, and lawyers.

The narrow market year-to-date has been concentrated in stocks deemed to be well-positioned in AI. As one example, technology companies that mentioned AI on their earnings calls outperformed other technology companies during April and May by about 3%. This is a short timeframe and shouldn’t be over-interpreted, but it does speak to the degree to which investors’ focus on AI is amplifying what has already been a narrow market year-to-date.

Looking Forward

As we look to the rest of 2023 and 2024, we see an economy that will continue to decelerate, while remaining reasonably solid, underpinned by strong household balance sheets and a strong labor market. We expect the narrow equity market will broaden out, although whether that occurs through underperformance of the few leaders year-to-date or by appreciation of the rest of the market is not clear. We expect that 2023 will continue to be a “muddle-through” year.


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