Over the near term, we continue to anticipate that market returns will be largely shaped by whether the U.S. economy succumbs to recession and the related central bank policies. While the long-term outlook still looks bright to us and we don’t recommend major changes to portfolio positioning at this stage, we think the lingering uncertainties require more patience from investors and a wider perspective.
Recessions are normally the difficult periods for equity markets, but those periods do not dominate the investment landscape. Since 1945, the U.S. economy was in recession for only 15 percent of the time, meaning that it expanded during the other 85 percent of the time. Looking at the long-term GDP chart, the economic pullbacks associated with recessions are either barely noticeable or not at all visible.
Operating earnings per share vs. nominal U.S. GDP
The line chart compares annual operating earnings per share for S&P 500 companies and the nominal U.S. GDP on a logarithmic scale indexed to 1945 = 100. The two data series track closely together, but earnings have risen faster.
Since 1945, nominal U.S. GDP has risen by 6.4% per annum, while earnings have risen by 7.3% per annum on average.
Source - RBC Wealth Management, Standard & Poor’s, U.S. Federal Reserve; annual data shown on a logarithmic scale
Making big portfolio asset allocation decisions based on the premise that the economy and already successful businesses could lose the ability to adapt to headwinds, or that the challenging periods are going to last much longer than they have previously, seems out of proportion with the historical record, in our opinion.
Following is a brief summary of the key takeaways from our Global Insight 2023 Midyear Outlook , which provides investment guidance for the next 6–12 months.
Equities: Rallies, recessions, and realistic thinking
The market rally from the September lows has moved far enough to turn many skeptics into believers. Joining other major markets in new high ground this summer is not out of the question for North American averages.
“Fear of missing out” has been propelling the North American averages higher and could go on doing so for some months yet. But the attractive valuations of last September are giving way to loftier price-to-earnings ratios that we believe will need the economy to cooperate to be justified.
Reliable leading indicators of U.S. recession continue to worsen, suggesting to us that this latest advance in share prices will eventually give way to a more challenging period for equity investors.
We continue to recommend Market Weight equity exposure for a global balanced portfolio because we think this advance has further to go into the summer months.
However, we increasingly think individual stock selections should be restricted to companies that an investor would be content to own through a recession. For us, that means high-quality businesses with resilient balance sheets, sustainable dividends, and business models that are not intensely sensitive to the economic cycle.
Portfolio positioning by market:
- U.S. – We recommend maintaining Market Weight exposure to U.S. equities, an allocation that attempts to balance the heightened economic risks against the typical opportunities associated with a Fed policy shift. We would tilt portfolios slightly toward defensive sectors and dividend growers.
- Canada – We remain constructive on the energy complex, including the Canadian oil majors, as we think oil supply tightness points to higher prices through the cycle. Despite the multiple headwinds facing Canadian banks, we believe income-oriented investors with a long-term view can discover opportunities.
- Continental Europe – We favor leading semiconductor equipment manufacturers, electrical equipment providers that are supplying infrastructure for generative artificial intelligence data centers, luxury stocks, and select European Industrials stocks tied to decarbonization, automation, and onshoring trends.
- UK – We maintain our bias toward defensive, quality UK companies that generate a high proportion of revenue internationally and trade at a steep discount to international peers. Our preferred defensive sector remains Health Care, but Consumer Staples is becoming more appealing to us given cheaper valuations.
- Asia Pacific – Japan remains our preferred developed market in Asia partly due to positive structural changes underway. Going forward, we expect greater foreign interest to be another support for the equity market. For the Chinese market, we favor owning some defensive and high-dividend-yield stocks for downside protection and income.
Fixed Income: The “year of the bond” hasn’t been much of a year at all
The banner year for bonds that we expected in 2023 after a dismal performance in 2022 hasn’t materialized thus far, but we continue to expect steady gains as rate hike cycles near their end points.
While inflation remains elevated globally, we now have sufficient data in hand to suggest that the tide has indeed turned lower. Central banks will stay on high alert, and we believe a more cautious policy approach should limit economic risks. Before bonds can begin the kind of rally that we have been anticipating, inflation will need to be well and truly on its way back toward target levels, in our view.
We expect yields to fall in the back half of the year, but only modestly so as resilient economies are unlikely to see tight central bank policy give way to rate cuts—extending the window for investors to put money to work at historically high yields.
In the U.S., we have dialed back our return expectations somewhat from high single digits to something in the four percent to six percent range as we see bonds as likely to deliver little more than the coupons paid for the year.
For bond investors who don’t often worry about total-return potential but rather the income provided by their capital allocations to bonds—the outlook could hardly be better, in our view.
While we think central banks will take a more cautious approach going forward after a year of brute force, bond investors are in a unique—and privileged—position. From our vantage point, bond yields have rarely appeared more attractive, while at the same time bonds should provide strong capital appreciation potential for portfolios should prices rally if and when central banks pivot back toward rate cuts as economic growth and inflation eventually cool.
Midyear musings
For more details on the investment views and opportunities, as well as guidance for regional fixed income markets and forecasts for commodities and currencies, please take a look at our complete Global Insight 2023 Midyear Outlook . The individual feature articles are also available separately: “Rallies, recessions, and realistic thinking” and “The ‘year of the bond’ hasn’t been much of a year at all.”