Opportunities on the Horizon: Investing Through a Slowing Economy

Regional Previews | WEALTH OUTLOOK 2023 | MID-YEAR EDITION | 70 FIGURE 1 : Conflicting Positives and Negatives for the US Equity Market Outlook Tailwinds Headwinds Resilient employment in services sustains consumer spending High Fed policy rates, Quantitative Tightening (QT), reduced bank leading, restrained capital entrepreneurs Inflation slowing Weakening commercial real estate fundamentals, spillovers to SMID banks Strong corporate balance sheets, private credit availability Treasury Bill issuance to surge post-debt ceiling agreements Inventories are heading down (housing and manufacturing), “working off” a recession Failing labor productivity to weaken labor market Historic high equity short positions and large cash balances China and EU economies gain less than expected on initial China reopening Estimated EPS far above achievable corporate profit gains (record high expected by 4Q 2023) Source: Citi Global Wealth Investments Both employment and inflation are heading down US employment dropped by a record amount in 2020 and as the economy subsequently recovered rapidly, many employers could not find basic labor. Many firms in 2023 are still hoarding labor as a result. Over the past fewmonths, layoff announcements have accelerated, most notably in technology, finance and construction. This is in response to the fact that six of the 11 major sectors of the S&P 500 were in “profit recessions” after their first quarter 2023 results. Employers have also been cutting temporary workers. Positive economic signs, too Despite the string of negative developments, there are positive areas within the US economy. Inflation has decreased from 9% in June 2022 to 5% in April 2023 and we forecast it will drop to 3.5% by the end of the year (See Recession, recovery: A journey unfinished ) . A measure of global supply chain pressures tracked by the New York Fed has returned to pre-pandemic levels. A reduction in goods inventories is beginning while services spending is keeping the broader growth rate of the economy positive. This is gradually setting the stage for a stronger growth period within 2024. We still believe the Fed’s aggressive fight against inflation and the current delay in labor market weakness will ultimately cause the Fed to reverse course toward the end of 2023. This sequence of events suggests that the currently high overnight money fund rates and high yields of the shortest- term T-bills will not be available a year from now. We also expect the 10-year US Treasury yield to decline to 3% at the end of 2023. Historically, the stock market has bottomed when the Fed lowers rates during a recession. In the present case, investors built record high short positions on the expectation of recession in 2022. While US equities still face risks, considerable bad economic news has been digested. And then there is generative AI (See Generative AI: The beginning of (another) technological revolution ) . The introduction of a new technology that is likely to rival the internet in its impact on the US and world economies has led to new highs for firms able to provide the infrastructure for its rapid adoption. Cash waiting to invest Investors have juggled a laundry list of risks, from the recent debt ceiling brinksmanship to tight Federal Reserve policy to further EPS declines, that could trigger an elusive-until now- equity market selloff. With huge cash balances on the sidelines, potential “dip-buyers” have kept US equities range bound. During this time, a very large valuation discount has developed in profitable small- and mid-cap companies that face immediate economic risks but are poised for stronger returns in a recovery period. Our new 10-year strategic return estimates (See FIGURE 3: Recession, recovery: A journey unfinished ) reflect the brighter prospects for markets after the material equity and debt declines of 2022.