Inverted Yield Curve

July 2023 - Despite expectations, the global economy has managed to avoid a recession recently due in part to consumer resiliency, increased travel, and China's economic reopening after pandemic-related lockdowns. However, economists continue to predict a mild recession in the second half of the year as a result of high interest rates, persistent inflation, and a potential banking sector crisis.

While inflation is decreasing, it remains elevated, impacting some parts of the economy more than others. Consumer price increases are still above the Fed's target, and inflation is turning out to be stickier than expected. In response, aggressive and very rapid interest rate hikes by central banks have triggered a crisis in the banking sector. Specifically, if short-term rates continue to increase, or remain elevated for an extended period of time, the risk of additional bank failures increases, creating the likelihood of additional financial and economic decline beyond the financial sector. The Fed has signaled a pause in its rate-hiking campaign to assess the impact of the banking crisis and could potentially cut rates by year-end.

The inverted yield curve, among other financial indicators, like commercial real estate vacancies due to remote work adoption, also point to a looming recession in the United States. Estimates of a decline of around 1% in the U.S., flat to slightly negative growth in Europe, and 2% to 3% growth in China are trending expectations.

Source: U.S. Department of the Treasury

There seems to be a new economic paradigm developing characterized by supply chain constraints, worker shortages, and increased inflationary pressures. In this new environment, traditional asset class returns may be less favorable, and investment strategies will need to adapt to these changing conditions.

The global economic environment has experienced a significant shift from the previous period of stability and low inflation. One factor, the persistent supply chain problems of late, are the result of a number of variables. First, the world is experiencing a rise in geopolitical tensions and the reorganization of global supply chains as a result. This is leading to increased production costs and will likely result in reduced economic efficiency and productivity generally. Also, as governments focus on transitioning to a low-carbon economy to address the moving target of climate change, energy costs are expected to rise over the next decade, adding additional pressure to suppliers.

Other social themes impacting this evolution in many developed economies, including the United States, the Euro area and China, are declining working-age populations. This leads to worker shortages, wage pressure and increased demand for healthcare and other services for the elderly. Also, advances in artificial intelligence and other digital technologies are disrupting traditional industries and job markets, creating winners and losers in various sectors.

Given this new economic landscape, as central banks are expected to maintain tight monetary policies to combat inflationary pressures, income assets like short-term U.S. Treasuries are favored for their potential to provide real income in excess of inflation. Generally, slowing growth and persistent inflation in major economies favor a preference for emerging markets and high quality income assets.

In the face of greater market volatility and divergent security performance, it will be important to focus on specific sectors and companies that are likely to benefit from shifting macroeconomic trends and transformational forces. The S&P 500 has experienced solid year-to-date performance, but there are growing concerns about the rally's durability. Market gains have been driven by a handful of mega-cap growth stocks, narrowing the leadership within the index. Also, developed non-US stocks have enjoyed an increase in earnings estimates and outperformed the S&P 500 in several months this year. Europe's resilience over the past three quarters has surprised investors, and European equities are leading in terms of macroeconomic and earnings fundamentals among their developed peers. In this new economic paradigm, static asset allocations may not be as effective, and investors will need dynamic and nimble approaches to portfolio management.

In closing, diverse portfolios with both cyclical and defensive stocks to navigate potential economic downturns, along with a focus on quality will be rewarded in the long-term. Investing in companies with stable cash flows and durable balance sheets will add fundamental strength to portfolios. Quality has historically outperformed the broader market in economic slowdowns, highlighting its ability to reduce equity downside risk. As always, we recommend slow and steady with effective diversification and thoughtful allocation.

Thank you for allowing us to be your trusted advisor. Your trust is our most valued asset. If your financial situation has changed, or you would like to reassess your risk tolerance, please contact us. We look forward to visiting with you and answering your questions.

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