Mid-Year Update

June 27, 2023


  • The driving force behind recession predictions from economists has been tightening monetary policy.
  • While the service sector, which accounts for a significant portion of GDP, remains robust, the manufacturing side of the economy is facing challenges due to its higher sensitivity to interest rates.
  • The labor market is displaying signs of weakness, with jobless claims increasing and the average number of hours worked in the private sector reaching a three-year low. Inflation, however, has continued to persist primarily in core services, though supply-chain pressures have eased, shipping costs have fallen, and commodity prices have declined.
  • The US Federal Reserve maintained its policy rate but revised upward its prediction for the rest of the year, expecting two additional rate hikes.
  • There is a wide disparity for U.S. stock market returns in 2023, with large cap growth stocks leading the way due to a perceived safe haven in the face of a possible recession and the AI ‘meme theme.'

The Economy

Anticipation has been building among a multitude of economists in 2023 as they forecast a high probability of a recession this year. However, their concerns have not gone unnoticed by the general public. In fact, a quick glimpse at Google trends reveals a substantial surge in searches for the term "recession" just one year ago, with varying levels of interest throughout the current year. What is driving these recession predictions? The simplest answer is: tightening monetary policy.

Despite interest rates being lifted to get the economy to soften and inflation to come down, fiscal policy from the government remains relatively stimulative, helping to counteract the tightening. Additionally, real interest rates are not yet constraining (the nominal yield on Treasury bills remains at or below the core inflation rate and nominal GDP growth), the household sector still has significant savings built up during the pandemic (when rates were significantly lower), corporations extended the maturity of their loans, and the service sector, which is less sensitive to interest rates and accounts for approximately 78% of GDP, remains strong even as economic growth has slowed.

So, while the service sector of the economy is clinging on, the manufacturing side is challenged due to a higher sensitivity to interest rates. Surveys of manufacturing sentiment remain in contractionary territory, and another measure to gauge the strength/weakness in the goods sectors is that of sales of cardboard boxes.

Looking at the chart below, it’s not hard to point out the weakness in the goods sector of the economy.

That said, the labor market is showing some cracks with jobless claims starting to tick up, while the average number of hours worked in the private sector slid to the three-year low.

Inflation has persisted due to core services such as shelter, transportation and recreation. However, easing supply-chain pressures, falling shipping costs, and lower commodity prices are counteracting services pressure a bit. Unfortunately, the Federal Reserve isn't quite celebrating yet despite some of the advancements made because their favorite indicator (Core PCE Price Index) has flatlined.

Source: Bureau of Labor Statistics. US Core PCE Price Index as of 4/30/2023. US Core CPI Index and US CPI Index as of 5/31/2023.

Hawkish Hold

On June 14th, the US Federal Reserve maintained its policy goal range of 5.00% - 5.25%, as expected by market participants, but revised upward its prediction for the rest of the year. It now anticipates two additional rate hikes from current levels, an increase from zero previously.

Coupled with the policy statement released, the updated Summary of Economic Projections (SEP) illustrated that the committee is leaning in a more restrictive direction. The GDP growth prediction for this year has been increased upward, while the estimated unemployment rate has been trimmed downward. But most importantly, the expected inflation rate was revised higher.

In his press conference, Chair Powell signaled the possibility of another rate hike in July, but incoming U.S. inflation data will be a key item determining that decision. Market participants no longer anticipate rate cuts in 2023 as of the time of this writing.1 Numerous rate decreases were anticipated just a few months ago.


On the surface, broad U.S. stock market returns in 2023 are good news for investors. The Russell 3000 Index showed that the U.S. market was up about 13% towards end of June, significantly above the market's long-term average monthly return of about 1%. Yet, this masks several major headlines that faced markets in the first half of the year—ongoing fears with regional banks, the U.S. debt limit deadline, and persistent rate hikes.

Peeling back the onion on the U.S. stock market returns in 2023, we see a wide disparity between U.S. large growth and the rest of the market. The dispersion in returns between U.S. small value stocks (-0.79%) and U.S. large growth stocks (+24.83%) is around 25% on the year.

Data from 12/30/2022 to 06/26/2023. U.S. stocks are represented by the Russell 3000 Index. U.S. large growth stocks are represented by the Russell 1000 Growth Index. U.S. small value stocks are represented by the Russell 2000 Value Index.

Considering the substantial year-to-date disparity, a retrospective glance to March 1, just before news of turmoil in the regional banking sector surfaced, reveals a period when small value assets were surpassing both large growth investments and the overall market performance for the year. Succinctly put, the dynamics of markets can undergo swift and decisive transformations.

Beyond the banking crisis, we believe that investor concerns over an impending recession resulted in a rotation out of value and into growth stocks (value stocks tend to be more sensitive to a declining economy), and artificial intelligence, according to Scott Welch at WisdomTree, became the ‘meme theme,’ which massively benefitted the mega-cap tech stocks.

Looking at the year-to-date performance of the S&P 500 Index with and without AI-influenced stocks, practically all of the S&P 500 Index performance this year has been driven by mega-cap tech stocks.

Just like broad asset classes like stocks and bonds, sub-asset classes within stocks can zig and zag as we move through different market regimes. This is the reason diversification within broad asset classes and sub-asset classes can help provide a more consistent performance over longer market cycles.

Back Half of Year

As the market has moved on from the troubles experienced earlier this year, the equity market “fear index” (VIX) has fallen to pre-pandemic lows. Fed actions, investor sentiment, and prospects for an earnings decline will determine volatility moving forward.

Market leadership remains extremely narrow, and the question for investors now is whether the rest of the U.S. equity market will begin to participate, resulting in further upside for stocks broadly, or whether the U.S. equity market will simply churn over with profit-taking in big tech used to fund a broadening of performance, limiting overall return potential at the index level. Ultimately, time will tell.

(1) Bloomberg

Important Disclaimers and Disclosures