Finance & Banking
It’ll take a while for the transformative effects of artificial intelligence to wend through society, often in unexpected ways. But AI has already pulled off one improbable feat — levitating the stock market. Despite still-considerable uncertainty about inflation and the economy, the market has zipped higher, thanks largely to a smattering of technology giants riding a crest of AI enthusiasm.
The rally has been underpinned by another surprise — the economy’s tremendous resilience in the face of concerted Federal Reserve rate hikes. Though growth is slowing, the job market has stood its ground while consumer spending has hummed along. None of the worst-case outcomes that investors feared early in the year — stifling inflation, a banking collapse, a government debt crisis or, most of all, a recession that once felt baked in — has materialized.
That’s raised hope that the economy might be able to skirt a long-predicted downturn. Or, more likely, that a recession would be brief and mild — a palette cleanser of sorts on the way to a protein-rich recovery. A number of signs appear to support that logic: Though the Fed is expected to keep up the pressure this year, rate cuts are possible in 2024. Global GDP and earnings are projected to pick up next year. And business and consumer finances are relatively strong compared to soft patches of the past, meaning there may be ample firepower to fuel growth when the tide turns.
The headline-grabbing advances in artificial intelligence have led the way amid hope that AI represents the next great technological leap — potentially on par with the advent of the internet and the introduction of smartphones. The likelihood that rate hikes are nearing an end has also helped. That could aid both the companies themselves, some of which borrow heavily in pursuit of ambitious growth, and their stocks, as investors are more willing to overlook high valuations and far-off earnings when rates are stable or declining.
All of that contributed to the S&P 500 Index rising 8.7% in the second quarter and 16.9% so far this year. Though proclamations of bull and bear markets are as much art as science, the S&P 500 technically closed out the lengthiest bear since the 1940s, with a new bull now underway.
Of course, as the first half demonstrated, the best-laid projections sometimes don’t pan out. The threat of recession remains elevated, with indicators such as unemployment claims and consumer sentiment suggesting weakness ahead. Given the lagged effect of rate hikes, the full impact of the Fed campaign has yet to be felt.
Inflation has been both a bright spot and a sore one. Consumer price hikes dipped to 3% in June, the slowest pace in more than two years and down considerably from the 9.1% peak a year ago. Still, that exceeds the Fed’s preferred rate of 2%. And core prices, which exclude volatile food and energy, rose 4.8%. The risk is that the Fed and other central banks keep the clamps on longer than expected. The implosion of three U.S. regional banks earlier this year could create an additional economic drag as institutions tighten lending standards.
Capital Group’s macroeconomic research team foresees the U.S. economy declining 1% this year, with Europe flat to slightly negative, and China growing a restrained 2% to 3%. The Capital Group forecasts are slightly below the consensus estimate in the marketplace, largely due to the view that inflation could exceed expectations.
For the stock market, a lot may depend on whether breadth widens beyond the so-called “Magnificent Seven” tech stocks that accounted for the bulk of the S&P 500’s second-quarter gain. For the year, the seven stocks are up a collective 61%. The other 493 have advanced just 6% — an extremely high level of concentration. The market has recently showed signs of broadening. Absent further progress, though, reliance on a small cluster of stocks can be risky because a turn in their perceived fortunes could yank the market down.
China is also a source of uncertainty. After a short-lived burst of energy following the lifting of its restrictive pandemic lockdowns, the outlook for growth has cooled noticeably. The Chinese economy is matted down by soft export demand, ongoing retrenchment in its housing market, record high youth unemployment and a reluctance among consumers to open their wallets.
The central bank has responded by cutting interest rates on business and consumer loans. But the government has resisted more forceful measures, such as a massive spending program, in part out of fear that it could aggravate the debt woes China has struggled to contain without doing much to replenish consumer confidence.
Fixed income weakened slightly in the second quarter as the sunnier economic outlook caused yields to rise. However, the bond market remains positive for the year and, more important, fixed income has resumed its historic role of providing a measure of defense when volatility strikes equities. When bank woes and economic worries hit early in the year, bonds rallied as interest rates fell rapidly.
Capital Group portfolio managers remain focused on bonds with high credit quality given the risk of the economy weakening in the second half of the year. Credit quality is notably high among investment-grade municipal securities. Revenue from personal income taxes, corporate taxes and sales taxes are all well above pre-pandemic levels.
Within fixed income, spreads in mortgage bonds look attractive. Asset quality has been strong, suggesting low default risk. Over the past 10 years, the yield on mortgage bonds, as measured by the Bloomberg US Mortgage Backed Securities Index, has exceeded that of Treasuries by an average of 0.35%. The current spread is 0.52%.
One particularly notable result of rising yields has been better returns from cash, which were paltry for much of the past decade. That can create an understandable urge to have excessive exposure to cash. But that can weigh on long-run returns as equity and fixed income have traditionally outpaced cash by wide margins over the long term. And both asset classes have tended to do well when the Fed stopped raising rates.