Can the Stock Market’s Rally Keep Going? Strategists on What’s Ahead.
Inflation will fall further, interest rates could slip, and the recession has been postponed. How to invest in a "moderating" market.
So far, 2023 has confounded economists, humbled forecasters, and rewarded investors. Despite a rapid rise in interest rates, the U.S. economy continues to grow. Inflation has fallen—if not quite to desired levels—and stocks have entered a bull market, with the S&P 500 gaining 17% year to date and the Nasdaq Composite up more than 30%.
Neither the economy’s resilience nor the market’s strength seemed obvious, or even likely, at the end of 2022, a year that saw the Federal Reserve raise interest rates by more than four percentage points to combat soaring inflation, and the S&P 500 fall by 19%. Yet, the skies have been mostly sunny this year over Wall Street and Main Street alike, and the forecast for fall is more of the same, although with a bit more haze.
Wall Street’s top strategists are divided on the near-term outlook for stocks, which depends in large part on the economy’s future course—and the Fed. The most bullish case for financial markets is the Goldilocks case, or “just right” conditions, including an orderly retreat in inflation and a steady economy that keeps consumers spending and enables corporate profit growth.
For the optimists, a recession this year is no longer in the cards. “Everything has been pushed out from a macroeconomic perspective,” says Anders Persson, chief investment officer of global fixed income at Nuveen. “The economy is holding up better than expected. The consumer is stronger than expected.”
If inflation continues to slow, as it did in the past year, that would mean the Federal Reserve’s job is nearly done. A likely end to rising interest rates would be good news for stocks, paving the way for this year’s narrow, tech-focused rally to broaden. It would also allow bond prices to appreciate some. (Bond prices move inversely to yields.)
“We’re going to have a pretty good economy going into next year,” says Ed Yardeni, president of Yardeni Research. “The stock market is already looking into 2024 and discounting a better year, with less hysteria over an imminent recession.”
With continued disinflation, “the Fed’s next move [for interest rates] might very well be lower,” he says.
The bearish case also rests on a good economy—too good, that is. Recent data suggest that economic growth is accelerating, which implies stickier inflation than many had hoped. As a consequence, the Fed might need to tighten monetary policy further to restore price stability, rather than loosening it next year, the pessimists say.
“My guess—and I emphasize the word ‘guess’—is that the economy will be stronger than people think,” says Richard Bernstein, CEO and chief investment officer of Richard Bernstein Advisors. “That will force the Fed to continue to raise rates.”
Another worry is that the central bank will go overboard in attempting to vanquish inflation, raising interest rates to a level that pushes the economy into a recession. In that case, bond yields would rise, profit growth would diminish, and equity valuations would fall. Excessive tightening is “our No. 1 concern right now,” Persson says.
Worse, fiscal and monetary policy both could be hampered in ways that might prolong a potential downturn. “The Fed can’t really cut rates as aggressively as it has historically, given the inflation problem,” says Mike Wilson, CIO and chief U.S. equity strategist at Morgan Stanley. “On the fiscal side, it is already unprecedented to have a federal deficit of 8% [of GDP] when the unemployment rate is at 3.5%.”
The economy and the markets also could chart a middle course as 2023 segues into ’24, wherein the economy stagnates but doesn’t crash; inflation diminishes but remains above the Fed’s 2% target; and markets trade sideways for a while, as they have done for much of the summer. This seems the most likely course to Gargi Chaudhuri, head of iShares investment strategy for the Americas at BlackRock, and she isn’t alone.
“Moderation is the key word for the fall, both for the economy and inflation,” says Chaudhuri. “There are data points that suggest the potential for extreme moves on either side—an extreme recession or a sudden jump in growth—but I expect things will simply continue to moderate.”
As has been the case for the past few years, the Fed’s actions—or lack thereof—will heavily influence investors’ behavior. Fed Chair Jerome Powell is loath to repeat the monetary-policy mistakes of the 1970s, when Fed officials gave up their inflation fight too quickly, allowing price growth to reaccelerate. That necessitated another, even more aggressive tightening cycle, which took the federal-funds rate up to 20% in 1980.
Today’s fed-funds target range of 5.25% to 5.50% is far below that historic peak. But it is far above the near-zero rates that prevailed through much of the Covid pandemic. In Wall Street parlance, rates are likely to stay “higher for longer” as the Fed maintains its vigilance.
Most of the market strategists and chief investment officers whom Barron’s canvassed don’t expect the Fed to lift rates again in the current cycle, while a few are penciling in just one more quarter-percentage-point increase by year end.
Pricing in the futures market assigns roughly 50/50 odds to another rate hike before year end, according to the CME FedWatch Tool.
That’s the “higher” part. How much “longer” the benchmark rate will remain at today’s level is an open question, as Powell strongly suggested in his Jackson Hole speech on Aug. 25.
Much will depend on the course of inflation. If price growth continues to trend lower, monetary policy will tighten without the Fed’s further intervention, as the real rate of interest—the nominal rate minus the inflation rate—will rise. Even in the absence of a recession, the central bank might choose to cut interest rates in a falling-inflation scenario to maintain its policy stance at a consistently restrictive level, as laid out by New York Fed president John Williams in recent remarks.
Bond yields could decline modestly by year end, should investors see continued progress in taming inflation—and should the Fed indicate it has finished raising rates. Persson expects the 10-year U.S. Treasury note yield to finish 2023 with a yield between 3.75% and 4.00%, down by as much as half a percentage point from recent levels.
A harder economic landing in 2024, with more rate cuts, could result in an even bigger rally in Treasury prices, although a recession would hamper stocks.
Persson notes that bond prices historically have risen during the first three months after the Fed has finished raising rates in a cycle. In the meantime, he’s more excited about the fat yields on offer these days. “The vast majority of fixed-income returns come from the income generation,” he says. “Not very much ultimately comes from capital appreciation, [which requires] timing the market.”
Less-risky securities such as U.S. Treasuries represent good value today, with attractive yields that investors can clip while the bonds mature. Persson stresses the importance of diversification across different categories of fixed income, given the uncertain rate outlook. Nuveen Strategic Income (ticker: FCBYX) holds corporate bonds, government debt, mortgage-backed securities, and more, he notes. The fund has an effective duration of 5.3 years, an average credit rating of triple-B-minus, and a yield of 5.9%.
Bernstein’s firm has a neutral-duration allocation to Treasuries, with holdings in both short- and long-term securities.
Chaudhuri prefers the belly of the Treasury yield curve, the focus of iShares 3-7 Year Treasury Bond exchange-traded fund (IEI). It has an effective duration of 4.4 years and yields 4.3%.
Ten-year Treasury inflation-protected securities, or TIPS, sport their highest payout in 15 years: a 2% real yield. TIPS will outperform nominal bonds if inflation reignites. “I like to call them Totally Irreplaceable Portfolio Solutions,” Chaudhuri says. “Owning a 2% real rate in your portfolio is an incredible opportunity for investors.”
Falling inflation might be good for bond prices and stock market multiples, but it is a potential headwind to earnings growth, Morgan Stanley’s Wilson says. It will mean less pricing power and tighter profit margins for more companies. That’s just what Wilson forecasts; he expects S&P 500 companies to earn $185 this year, well below industry analysts’ consensus estimate of $220.
Wilson recommends overweight positions in healthcare and utilities. Healthcare stocks are “quality defensives,” he says, with relatively cheap valuations. The companies have decent growth and balance sheets, and little cyclical exposure. Utilities are defensive, as well, and tend to be the last sector to stumble in a market downturn. The Health Care Select Sector SPDR ETF (XLV) and the Utilities Select Sector SPDR ETF (XLU) are investment plays on these sectors.
Wilson is bearish on pricey technology and consumer discretionary stocks, and expects the S&P 500 to decline this fall, given the stocks’ large combined weighting in the index. He has a year-end target of 3900, implying a drop of more than 10% from recent levels.
Christopher Harvey, Wells Fargo’s head of equity strategy, thinks stocks may hit a rough patch in the near term. Bond yields could rise more in the coming weeks as Fed expectations continue to shift, he says. Plus, September historically has been a seasonally weaker period for the stock market.
Later this year, however, he expects bond yields to fall again and stocks to rebound, led by the biggest companies on the market. Harvey looks for the S&P 500 to trade in a range of 4200 to 4600 for the rest of the year, and end 2023 at 4420.
Harvey expects to see growing concern about the economic outlook for 2024 as the fall progresses. That’s a negative for cyclical stocks’ earnings but could prompt the market to price in Fed cuts next year, bringing down bond yields and helping growth stocks. The result might be a buy-what-you-know rush back into the market’s biggest, most successful, and theoretically most stable companies.
“For the top 50 companies in the Russell 1000, you’re paying only a 10% premium [over the rest of the index] for better earnings, stable growth, relatively low risk, and stronger balance sheets—and with an artificial-intelligence kicker,” Harvey says. “For an extra 10%, that’s an attractive list of things to have.”
The market’s largest tech stocks have rallied this year on growing investor enthusiasm for AI technology and applications.
Yardeni has a year-end target of 4600 for the S&P 500, and likewise expects megacap stocks to lead. “It’s pretty hard to knock those stocks down,” he says. “Every time they take a dive, it turns out to be a buying opportunity. People are consistently willing to pay a high multiple for those stocks.”
Bernstein takes the opposite view, noting that stocks such as Nvidia (NVDA), Meta Platforms (META), Tesla (TSLA), and Amazon.com (AMZN) each are up at least 60% year to date. Just seven stocks have contributed about 70% of the S&P 500’s rise in 2023.
Bernstein expects investors to pare their megacap holdings and redeploy the proceeds into other corners of the market this fall. “I don’t believe that there are seven growth stories in the entire world,” he says. “That is such a bearish view of the U.S. economy [and] the global economy. It does, however, make me excited about all the other overlooked opportunities out there.”
Specifically, he has been increasing his firm’s exposure to small-cap stocks, as he expects inflation to stay above 2% on an annualized basis, providing a tailwind to earnings growth. Small-cap indexes have a greater weighting than large-cap indexes in economically cyclical companies, and cheaper valuations than large-caps, characteristics that will give them the upper hand, he says.
Harvey likes mid-cap growth stocks, which also sport relatively cheap valuations and solid growth prospects and are positioned positively from a technical perspective. The risk/reward ratio is in the group’s favor, he says, with the potential for price/earnings multiples to expand and fundamentals to improve. More merger-and-acquisition activity would also favor midsize growth stocks, he says. The Vanguard Mid-Cap Growth ETF (VOT) provides exposure to the group.
BlackRock’s Chaudhuri assesses stocks through a factor lens, stressing quality characteristics that include strong balance sheets and stable earnings growth. Quality stocks, thus defined, could win in multiple macro and market environments, if not lead the market, she says. Chaudhuri recommends the iShares MSCI USA Quality Factor ETF (QUAL), which counts Nvidia, Apple (AAPL), Visa (V), Nike (NKE), and ConocoPhillips (COP) among its top holdings. The fund has returned 22% this year.
The S&P 500 isn’t grossly overvalued today, at 19 times estimated earnings for the coming year, but nor is it pricing in an adverse economic outcome. It is expensive relative to bonds: Yields on U.S. Treasuries are above their October 2022 highs, back when the index was around 3600 points.
“Typically, this is the way it is when we’re late in the cycle,” Wilson says. “In the absence of hard evidence, people’s views are dictated by price action. The fact that [stocks have] rallied so much has emboldened the view that a soft landing is more likely.”
Recent price action suggests that stocks will preserve most of their gains for the year, although the market might not trade much higher. Next year will bring fresh challenges—it’s an election year, after all—and the bill may come due for the economy after nearly two years of rate hikes.
Stick with quality stocks and a diversified bond portfolio, and look for bargains in cheaper parts of the market. Enjoy what’s left of the sunshine, while it lasts.
