2023 Midyear Markets Outlook

Susan Dziubinski: Hello, and welcome to Morningstar’s third-quarter 2023 U.S. stock market outlook. My name is Susan Dziubinski, and I’m an investment specialist with Morningstar.com. The U.S. stock market continued its upward march in the second quarter of 2023, thanks to stronger than expected economic growth, declining inflation, and investor exuberance around a handful of growth stocks. What should be on investors’ radars heading into the third quarter? Here today to share their outlooks for the market and the economy are Dave Sekera, senior U.S. market strategist for Morningstar Research Services, and Preston Caldwell, senior U.S. economist with Morningstar Research Services.

Time to Batten the Hatches? Or Raise the Sail?

Dave Sekera: Thank you very much, Susan, and welcome everybody to our market outlook. Good afternoon. I’m going to start off the webinar talking about our market valuation. First, I just want to address the title of this quarter’s overview: “Time to Batten the Hatches? Or Raise the Sail?” At this point, we’re up well over 20% from October lows. And I’ve been hearing more and more market commentators talking about how this is the beginning of a new bull market and that investors should be jumping into equities in order to be able to ride the tailwind for new market highs. But then I’ve also heard other market commentators, too, talking that this is really just a bull trap and a longer term of bear market, and that the market is overvalued, and actually now they should be selling equities while the getting is good.

Market Rally and Undervalued Stocks

I think both of these really missed the point, and during this conversation, I really want to highlight for investors what we think they should be doing today based on our valuations of our equity research analyst team. I think now is really a good time with the market rally to look for those instances where we think the market has risen too far, too fast and become overvalued, where you can take profits and then reallocate those profits into those areas of the market which have been left behind and remain undervalued today. With that, let’s just start off with our broad market overview and then breaking that down by the Morningstar Style Box.

Based on those over 700 stocks that are covered by our equity research team, we do see that the market is still trading at a discount, still trading at about a 5% discount to a composite of those fair value estimates, even after the market rally that we’ve had thus far this year. Now, of course, that rally really has been mostly driven by the growth sector. And at this point, growth is really getting to be pretty close to fairly valued at this point after being the most undervalued category at the beginning of the year. And so at the beginning of the year, while we advocated for a barbell-shaped portfolio, being overweight value, overweight growth, underweight core, following that rally in growth, with it now being pretty close to fair value, I think now is a good time to be taking profit in that growth category but still remain overweight in the value category. At this point, I think really some of the best positioning for investors will be to overweight value and be underweight both the core category as well as the growth category.

Valuations by Market Capitalization

And then taking a look at valuations by market capitalization, you know the large-cap category because of the large-cap growth stocks rallying so much, that’s trading a little bit less of a discount than the broad market. So again, another area that I think you can probably start to take some profits, start to underweight those large-cap categories and put that money back into work into the mid-cap and the small-cap categories where we see much better relative value and a lot of undervalued opportunities.

Thinking through what’s going on, the economy has certainly remained much more resilient than I think a lot of people had necessarily thought it was going to be at the beginning of the year. But looking forward, as Preston will talk about in his economic outlook section, we do think that the rate of growth will begin to start slowing sequentially and it will end up slowing in the third and fourth quarter before bottoming out in the first quarter of 2024.

Moving on here, how does this compare on a relative basis, throughout history? We are still undervalued, but I would just note that we are at much less of a margin of safety than we were even a few months ago. Now thinking about the market action over the second quarter, for the most part I’d say I think the bank failures are behind us. Looking at the stocks, especially the U.S. regional banks, I think a lot of those stocks, looks like from our market technician point of view have bottomed out and are probably treading water and we think that they’re undervalued at this point. While we do think that there’s still some volatility there over the next couple of quarters, we do see a lot of undervalued opportunities.

Economic Outlook 2023

As mentioned, the expected economic growth has been much stronger than expected, but really in the second quarter, I think a lot of the market gains that we really saw were investor sentiment regarding artificial intelligence and the long-term potential there. And that’s really what drove this unusual rally that’s been concentrated in what’s been called the Magnificent Seven. Seven stocks are responsible for about three quarters of the market gain through June 26.

Now thinking forward in the second half of the year, I do think that the markets might get tested, and as we see that weakening or that slowing rate of economic growth over the next couple of quarters and that does pressure earnings growth with less of a margin of safety, we could see some pullbacks here and there. But I just don’t think that any of those pullbacks will be anywhere what we’ve seen in 2022. At this point for the rally to continue, I do think it’s going to need to spread out to the broader market. More specifically, it’s going to have to spread out into the value category, and then it’s also going to have to spread out into the mid-cap and the small-cap stocks as well.

Midyear Market Recap

Just a quick review of how we got here year to date. So through June 26, the U.S. Market Index, which is Morningstar’s broadest measure of the stock market, was up 13.2%. But, as you can see, predominantly driven by growth over 23% return year-to-date through the 26th. Now looking at some of the other categories, the growth category up 5.8%. To me, that’s actually a pretty solid return. I think in a normalized year people would be pretty happy with almost 6% for half of a year. And then the value category, which has certainly lagged far behind, only up just shy of 2% for the year. Looking at it by capitalization, the large-cap stocks, being the big winners, up 16%, and then mid-cap and small-cap stocks up 5.2% and 6.6%, respectively.

Taking a look at the evolution of our price to fair value from the end of this year to this year, you can see at the beginning of the year, we did think the stock market was pretty significantly undervalued, trading at a 16% discount to our fair value, now moving to only 5% discount. And growth stocks, being the big winners, they were the most undervalued at the beginning of the year, trading at a price/fair value of 0.77, now only at a couple percent discount. Whereas the value stocks, with the lag that we’ve seen there, still trading pretty close to where they were on a price/fair value basis at the beginning of the year. And then also looking at the evolution of the large-cap stocks, how they’ve moved much closer to fair value, whereas the small- and mid-cap still remain at pretty large discounts.

Taking a look at returns by sector: I think I would just note here what we’ve seen is that the sectors that were, in our view, the most undervalued by our calculations coming into the year are the ones that have seen the greatest returns thus far this year. The communications sector, which was the most undervalued coming into the year, up almost 32% through June 26. Consumer cyclicals, which were the second-most undervalued, up 25%, and technology, which was the third-most undervalued at the beginning of the year, now up 37%.

And it's those sectors that we thought were either overvalued or at least fully valued at the beginning of the year that have struggled the most. The energy sector down over 8% through the 26th, that was the sector we highlighted at the beginning of the year as being the most overvalued, and then utilities and healthcare, two other sectors that were slightly overvalued, the fully valued at the beginning of the year, selling off as well. And then lastly the financial-services sector, which certainly had a tough time earlier this year following the failure of Silicon Valley Bank, Credit Suisse, and a couple of other banks. But it does appear that it’s bottomed out, and we do think that there’s good opportunities for investors in that area going forward.

Taking a quick look at the Magnificent Seven here, and again, these are the seven stocks that really have contributed about three quarters of the total market return this year. You can see with the Morningstar US Market Index how large of a weight these individual stocks have. They are all large- and mega-cap stocks. So of course they will skew the market. Movement based on just the size of them but also just looking at the year-to-date returns on these and just how much they’ve really outperformed the market. And several of these from Nvidia to Microsoft to Meta—stocks that I think really got caught up with a lot of the enthusiasm regarding artificial intelligence. The only thing is I would caution investors at this point: We really think that this has probably already run its course at this point in time.

When we look at these stocks, at the current valuation levels versus where they were at the beginning of the year, I’d note six of those seven stocks were either 4-star or 5-star-rated stocks. So again, stocks that we thought were pretty significantly undervalued at the beginning of the year, at this point, only Alphabet still remains undervalued. Several of these other stocks are all now trading within that 3-star category, meaning we think that they’re trading pretty close to fair value. And two of them, Apple and Nvidia, are now actually trading in 2-star territory. So again, we think that these stock prices have run up too far, too fast at this point in time. And those would actually be two stocks that I would highlight that I think now is probably a pretty good opportunity to take some profit in those names and be able to use that in order to invest in other areas of the market.

Stock Market Outlook

Thinking through what is going to impact the market in the second half of this year and going into next year, some of the macroeconomics, we do watch what the Federal Reserve is doing. So they have paused. Certainly looks like they’re going to hike again here at the July meeting. Now, the inflation rate is still running hotter than the Fed would necessarily prefer, but we do think that inflation is moderating. I think the real question here is: What is the Fed going to be doing after the July meeting? Is that going to be the final interest-rate hike of the year, and is that going to be the final interest-rate hike of this monetary policy tightening cycle? And following that, then the next question is: When is the Fed going to begin loosening monetary policy? Both of those questions, Preston will be able to answer in his economic outlook.

Inflation

As far as inflation goes, it is a different story now. It has continued to keep moderating, maybe not necessarily as fast as the Fed would prefer, but we do project it will remain on a downward path in the second half of this year and noting a lot of the major components that had driven that inflation higher are continuing to recede. And we do have a nice long-term outlook of inflation, getting back to the Fed’s target and staying there over the next couple of years.

Economic Growth

And then lastly, just getting back to the rate of economic growth. We do expect that growth will end up slowing sequentially over the course of the second half of the year before bottoming out in the first quarter of next year and then having a nice tailwind there thereafter. So with the market trading much closer to our fair value, there is a much smaller margin of safety at this point. I do suspect that we could see some selloffs in the second half of the year, really as the market is looking at a slowdown in earnings growth as well. But I do think that if we did have a selloff, it’s going to be relatively shallow. It’s not going to be anywhere near the magnitude of the decline in 2022.

For those of you that might have been part of our webinar at the beginning of 2022, we had noted that there were four main headwinds at the beginning of 2022 that the market was going to have to deal with. I think we’re in a very different situation today than we were back then. At that point we had noted that we thought the markets were overvalued. We noted that the Fed was going to have to tighten monetary policy at that point, inflation was running hot, interest rates were expected to rise. A lot of those headwinds are now either at this point having abated or even starting to turn into tailwinds in our view.

Sector Valuations and Top Picks

Let’s change topics here and start moving into some of our sector valuations and top picks. With the market being as concentrated as it is, we haven’t seen that much of a shift in our star ratings. So the percent of 4- and 5-star rated stocks did decrease slightly down to 45% from 52%. But maybe not as large of a decrease as I would have expected. You know, when we see the market up 13% in just two quarters. And the number of 1- and 2-star stocks did rise up to 15% from 11%. But again, still showing that there aren’t necessarily that many stocks we think are overvalued at this point.

Looking at some of the individual sectors, I’d highlight real estate, one of those sectors that really had been hit hard this year, does have the highest percentage of undervalued stocks. Then close behind that are the basic materials and communication sectors. And then it’s the consumer defensive and industrials that we think are the most unattractive, having the highest percentage of stocks under our coverage that are overvalued at either 1- or 2-star ratings.

Overvalued Tech Sector

Taking a look specifically at where we are on a price/fair value basis by the individual sectors, following a 37% surge year-to-date, technology is now the most overvalued, trading at about a 7% or more premium to those fair valuations. Again, this is the first time we’ve seen technology now in that overvalued territory since the beginning of 2022. I do think now is a good time to start moving to an underweight in that sector and start selling some of those stocks that have run up too fast. To the undervalued side, I would say looking at communications, again that was the most undervalued coming into the year. But with that being up 32%, it’s actually still the most undervalued sector, trading at about a 20% discount to fair value.

Real Estate is Undervalued

The real estate, now the second-most undervalued. Now within real estate, I’m still very skeptical of valuations for the urban office space, but away from that, we do see a lot of value there for investors. I think it’s one of those things where that office space valuations has really brought down the entire sector. And so I think with that, it provides the opportunities for investors to look at more idiosyncratic situations among some of the REITs that we cover.

Financial Services Are Volatile and Undervalued

Financial services, especially the regional banks, a lot of undervalued opportunities there, although I would say maybe a little bit more volatility. We’ll see where those results come out for the second quarter, just how much more deposit loss maybe we’d see in some of those regional banks. But I know from our equity analyst team that they would note that while we do think that the regional banks are under stress, we don’t think the business model is broken. Again, another area for investors to look for undervalued opportunities today.

Energy Is Becoming Attractive

Lastly, I would note that the energy sector is now becoming more attractive, not necessarily that far undervalued compared to the broad market, but again that was the most overvalued sector coming into the year, and so now we do see some more opportunities for investors there. Then lastly, the defensive sectors, those are the ones that held their value the best in 2022. Those came into this year being pretty fully valued, or at least fairly valued, and are still in that same kind of category, although we’re seeing maybe a little bit more individual opportunities here and there.

Running through some of our best picks from our analyst team, I would note that in the basic materials area, we’ve got three new best picks here. I would note that Albemarle takes the place of Lithium Americas. Again, we’re still very constructive on the lithium sector over the long term. Two new ideas to take a look at Corteva and Dow. And then also for those that are interested in gold, I’d note that we did pick up coverage of a number of different gold miners over the course of the quarter as well. And I know Barrick Gold is going to be our pick there for the gold miners.

And then the other one I would highlight on this page is going to be Federal Realty Investment Trust. So again, we do have a positive view on foot traffic coming back into the retail space. And that would be one name that I would highlight in addition to the Class A malls like Simon Property that we’ve talked about a number of times in the past. Among the economically sensitive sectors, we have a couple of new opportunities here in the communication services group, Verizon Communications being one of those: very undervalued, high dividend-paying stock, lot of margin of safety there. AT&T, its competitor, also would be one that I would highlight as well, but also an interesting name here is going to be Pinterest.

So taking a look at Pinterest and looking at what’s been going on in the digital advertising space, we’ve seen Alphabet move up quite substantially thus far this year. Meta has more than doubled, and so I think investors might be looking for other opportunities in that digital advertising space. Pinterest is one—it’s covered by the same equity analyst as Alphabet and Meta—that I think is worth a look for investors today.

Couple of new opportunities in the energy sector. Again, while the majors still look as though they’re probably pretty close to fair value. I know among the large majors, Exxon is still our pick there. I think it trades at about a 9% or 10% discount to fair value, but really the best evaluations we see are still among the services companies. In this case, Schlumberger is our pick in that sector.

Taking a look at industrials: Three new picks here as well, Dover, Jacobs, Stericycle. Stericycle, I think, is interesting. I think that’s one of those companies with the narrow economic moat, on the smaller side, maybe not all that well-known, but a company that I think pretty rarely trades at much of a discount to our fair value. So I think that one’s worth a look. And then Jacobs Engineering, again, I think that one’s got pretty good tailwinds behind it. Just thinking about some of the actions that have been put in place over the past year or two regarding infrastructure, thinking about the infrastructure spending in the Inflation Reduction Act. I think a lot of the engineering and construction companies are going to have a good tailwind for the next couple of years. And then lastly, a couple of new picks. Cognizant and Teradyne in the technology sector.

And then just wrapping up here with the defensive picks, I’d note among the consumer defensive ConAgra, I believe is a new pick here. Now again, it’s a no-moat-rated company, typically try and stay away from the no-moat and really focus on wide and narrow moat, but again, trading at about a 26% discount to fair value. I think that’s enough margin of safety to take a look at that name. And then lastly, the other one I’d highlight here is going to be Zimmer Biomet. So again, this is a returning name to the list, but I do think there’s going to be good tailwinds behind the medical-device makers.

Specifically UnitedHealthcare, one of the large insurance companies for healthcare insurance, did note relatively recently, and their stock actually sold off on the news, that they had been seeing a pickup in demand for healthcare services. I believe that indicates that a lot of delayed healthcare services, including things like joint replacements, that had been put off during the pandemic are now starting to come to fruition, so I think Zimmer Biomet and another one, Medtronic, would be two names that I think investors should take a look at.

Valuation by Economic Moat

Then let’s just wrap things up here and take a look at valuation by economic moat. I’d note wide-moat stocks have had a very good year thus far this year. Through June 26, the Morningstar Wide Moat Focus Index has risen just slightly over 20%, well outpacing the broader market. However, and unfortunately, that now leaves us at a much lower discount to fair value than what we had seen at the beginning of the year or even at the beginning of the quarter. So this really now shows that those no-moat-rated stocks are the ones that are trading at the greatest discounts to fair value.

Again, everything has a price, and valuation is always really the utmost importance when investing. But I would caution investors just to make sure that you do pick and choose carefully among those no-moat-rated stocks when you’re looking to invest.

And I’m not going to run through all of these, but again, just showing how you can use some of the Morningstar screening tools in order to help identify undervalued opportunities that might be right for your portfolios based on your risk tolerance. In this case, looking at those undervalued large-cap stocks with wide economic moats and Low or Medium uncertainty levels and then just rank order from the most undervalued on up. A similar screen here for mid-cap stocks. And then lastly, doing the same screen for small-cap stocks. Now in this case because with the small caps we don’t see as many companies with a wide economic moat, I also did incorporate those companies with a narrow economic moat. But again, I think a lot of interesting opportunities here, especially in that small-cap space.

With that, I’d like to turn things over to you, Preston.

Preston Caldwell: Thank you, Dave. Good morning, everyone. So just to provide a little bit of context: In 2021, we saw one of the fastest recoveries in U.S. economic history. Now it was inevitable that things were going to cool off a bit heading into 2022, and indeed, we especially saw the impact of supply-side constraints. And so the strong demand that was propelling growth in 2021 ran into the brick wall of supply constraints, and the result was a jump in inflation, with inflation in 2022 hitting its highest level in over 40 years. And in turn, the Federal Reserve responded with the largest interest-rate hike in terms of the federal-funds rate in 40 years.

An Economic Slowdown

Nonetheless, the economy has slowed by far less than most would have thought in the face of those interest-rate hikes so far in the second half of 2022 and the first half of 2023 after that rate-hike campaign ramped up. However, I would say that most of the effects of Fed rate hikes have yet to fully play out in terms of the real economy. Therefore, we continue to expect growth to decelerate over the next 12 months in terms of the annual growth rate growth troughing in 2024, at 1.1%; after that, though, we expect Fed rate cuts to lead to a rebound in growth, with robust growth rates over 2025 to 2027, as you can see.

And those Fed rate cuts will be enabled by falling inflation. For this year as a whole, we expect inflation to dip below 4% and ending the year slightly below 3% in year-over-year terms. And then for full-year 2024 through 2027, you can see we expect inflation actually slightly below the Fed’s 2% target. With the fall in inflation driven most of all by easing supply constraints and also the impact of Fed rate hikes on cooling off demand.

Comparing our views to consensus: On GDP, we’re bullish compared to consensus forecasts. If you look at the longer-term forecasts that are out there, we expect actually a cumulative 5% more real GDP growth through 2027. This is driven partly by the labor supply side, where we expect greater labor force participation, and also on the productivity side, where I think consensus has overreacted to near-term productivity headwinds in the data, which I think more reflects noise and continuing temporary pandemic disruption than anything else.

Inflation Is Expected to Come Down

On the inflation front, consensus is expecting inflation to come down, but we’re even more optimistic, and you can see in 2024, we’re expecting, again, inflation below the Fed’s 2% target consensus. It’s at 2.6% for the full year, and the Fed, if you look at what’s baked into their latest projections, it’s about a 3% inflation rate for full-year 2024, so because we’re more optimistic than the market and especially the Fed on inflation coming down, we think the Fed will start cutting earlier and much quicker than is incorporated in Fed projections, as I’ll detail.

Interest Rates Forecast

Turning to our interest-rate forecasts: You can see we expect the federal-funds rate to ultimately dip from just over 5% currently to below 2% by 2026. In turn, we expect the 10-year Treasury yield to fall at least 100 basis points. Our long-term projection is 2.75% for the 10-year Treasury yield, and this will help enable a fall in the 30-year mortgage rate from 6.5% to 7% that it’s been averaging recently to below 4.5% by 2026 and 2027. And we think a large fall in the mortgage rate will be required to sustain a continued housing recovery, even though it does—some of the data has perhaps shown green shoots in recent months, I would say that’s probably ephemeral. You know, with housing affordability being as weak as it is right now, in terms of the median mortgage payment to household income, that having abruptly reached its worse level in well over 15 years. Unless we get a much greater fall in mortgage rates and much more affordable mortgage payments, we’re not going to see a sustained housing recovery, and housing is the most interest-rate-sensitive major sector of the U.S. economy, so that’s really key to look at in terms of how much monetary policy has to ease going forward.

Strong Activity Data

Looking at the near-term activity data, all of the hard activity data has been strong, with the partial exception of industrial production. Consumption has been volatile, but generally has continued to trend up. Employment has been the strongest indicator. And in fact, employment growth is really anomalously high right now. Employment was up 2.9% year-over-year in the first quarter, which actually exceeds GDP growth, up 1.8% year-over-year. And ordinarily it’s the reverse, right? You have GDP growth in excess of employment growth with the differential between those two basically being productivity growth. And so that means that businesses right now are hiring faster than they are expanding production of goods and services, and that can’t last forever lest it eventually cut into businesses’ profits. So businesses are going to dial back hiring, I expect, over the next six to 12 months so that they keep costs under control. And that will cool off the labor market substantially.

Now the one data point that does show continued weakness is the soft data in terms of, for example, the S&P Manufacturing PMI continues to show contraction in manufacturing activity on the horizon. However, I think that soft data, I’ve always been skeptical about it because it’s kind of a squishy survey that doesn’t really give you a firm indication on what’s going on in the economy. And I think especially it’s been disrupted by the pandemic because, for example, one of the main components of that index, the manufacturing PMI, is product backlogs, and we are seeing product backlogs fall substantially, but that’s mainly reflecting a normalization of supply chains rather than an imminent recession. I think those who have been making these recession calls based off of what’s going on in the PMI, I don’t think that’s appropriate.

GDP Forecast

Looking at the bottom chart, this shows our quarterly GDP forecast, and again, we expect growth to decelerate over the next several quarters. Troughing precisely sometime around the beginning of 2024 and then starting to accelerate toward the back half of 2024 as the Fed begins cutting interest rates and the market reacts to that.

Consumption Has Remained Solid

On consumption, real consumption has continued to remain fairly solid at 2.2% annualized rate of growth in the last three months. There’s been some volatility, which due to the holiday season being a bit unusual this year, consumers pull back on their spending in November and December. But then made up for that with higher spending in January and February, and all that volatility has made it a bit hard to infer the overall trend, but overall consumption has remained fairly stable. But what we see looking at the bottom chart is that households still have a very low savings rate compared to prepandemic levels: about over 400 basis points lower than their prepandemic savings rate. And that is not likely to last forever. What it appears is happening is that households are spending down that stockpile of excess savings that were accumulated during the pandemic. As you can see on the bottom chart, the savings rate in 2020 and 2021 was quite high; however, those excess savings are running out, likely within the next six months or so, and that will induce households to start to increase their savings rate to prepandemic rates in our view and that will slow consumption in the overall economy over the next six to 12 months.

Fed-Funds Rate Hike

Looking at our views on the fed-funds rate in more detail, looking at the top chart: We do expect one more rate hike in July. It looks like, looking at the latest Fed minutes, the committee is fairly set on that, and the data probably is not going to change their viewpoint dramatically over the next couple of weeks. However, we do think that this will be the last rate hike. And the first rate cut we expect to come in February of 2024. By then, I think the inflation data will have continued to have fallen enough and the economic activity data will also be weak enough that both parts of the Fed’s dual mandate will point toward the initiation of rate cuts, and we expect those to continue aggressively through mid-2025, ultimately with the fed-funds rate coming down about 200 basis points below what the market as well as what the Fed is projecting.

The counterpoint to this view is the idea that interest rates will be higher for longer. In other words, the regime of lower interest rates that we were in the prepandemic years will disappear and we’ll return to maybe the higher real interest-rate regime of the 1990s and especially the 1980s, but I don’t think that’s correct. I think there’s been structural factors in the economy like aging demographics, which mean that there is persistent downward pressure on interest rates, and we will see a return to the lower interest-rate regime prevailing prior to the pandemic. What we’re seeing right now is just a temporary cyclical upswing in rates.

Recession Risk and Commercial Real Estate

Thinking about drivers of recession risk, one of the main areas of vulnerability in the economy is commercial real estate, is high exposure in the banking sector, and much of the debt in this sector is variable rate or has a short maturity, and so there’s a lot more exposure to rising rates in terms of balance sheets. However, I don’t think there’s much reason to worry about a large bust in the commercial real estate sector. If we look at the top chart, total spending on nonresidential structures, that’s CRE and the national accounts basically, that spending, it wasn’t elevated in the prepandemic years and it’s even been down somewhat since the start of the pandemic, so share of GDP.

That’s a stark contrast with what we saw in the mid-2000s with the housing boom. You can see that was an exaggerated, highly exaggerated cycle in residential construction. We don’t have an excess of nonresidential building stock, which is going to create this large overhang on the economy. But admittedly one area that does look particularly vulnerable is offices, given the continuance of work from home. But offices only accounted for 13% of nonresidential construction in 2019, using prepandemic rates, or that’s just 0.4% of total U.S. GDP. So, offices are a very small slice of the U.S. economy.

Banking Sector Concerns

Looking at the broader banking sector, we have seen, after the precipitous outflows from the banks in March following the failure of Silicon Valley Bank, deposit outflows have ceased in the last four weeks or so. So there’s a lot less concern, I think, around a banking crisis for now. I think there’s still a risk out in the background as long as rates remain as high as they are, which, and also I would note that there’s still a huge differential between the kind of deposit rates being offered by banks and money market yields, which are of course tied to T-bill rates and the fed-funds rate. And so there is the ongoing risk of weakness in banking, but what I will say is that even with deposit outflows having ceased, and even if everything remains stable, we still will see a headwind from the banking sector on the real economy because banks have been planning for a while to cut back on credit issuance in order to match the outflow in deposits that’s already occurred. And in fact, we saw a tightening of credit standards even in the fourth quarter of last year and also the first quarter of this year, even before the spate of bank failures that occurred, as you can see on the bottom chart. And so that tightening of credit standards will lead eventually to a contraction in credit growth, which will slow on the economy especially nonresidential investment.

CPI Inflation Rate Has Fallen

Turning to inflation in more detail: The CPI headline inflation rate has fallen dramatically from a peak of 8.9% in the middle of last year to 4.1% as of this last month. That’s been driven most of all by energy. And also now food to a lesser extent, but if we strip out food and energy to get core inflation, and we look at the sequential rate of progress, which is shown in the bottom chart, the yellow line, it has been a bit disappointing in the lack of further downward movement, being sticky around 5% so far in 2023.

Now what’s happened is that the rate of inflation in shelter or housing basically has started to come down dramatically. That was the main driver of core CPI earlier in 2023, but at the same time we’ve seen a rebound in all other components of core CPI ex-shelter. And that’s been driven most of all by durable goods, in particular used-car prices, which have rebounded. But if we look at the leading edge data on wholesale prices for used cars, those point toward a renewal of used-car price declines in the next several months, which should bring down the durable goods component of the CPI quite dramatically. We do see further deflationary pressure around the corner coming from that. In addition to ongoing declines in shelter inflation—most of the data in housing is still pointing toward reduction in rent growth compared to what’s prevailed over the last year or so.

Inflation Forecast

Looking at our inflation forecasts broken out into key components: You can see the main driver of why we expect inflation to come under control over the next several years is that not only do we expect the inflation that we saw previously in food and energy and durable goods to cease, we expect it to reverse, to run in the other direction. We expect the spike in prices which occurred to unwind, for prices to converge somewhat back to their prepandemic trend in these industries, and therefore deliver a bout of deflation in food and energy and durable goods over the next several years. And that is already starting to play out to a great extent.

Housing Inflation Is Expected to Normalize

Housing inflation we also expect to normalize, and then the rest of the economy, the main driver there will be what happens in labor markets, and I’ll talk more about that. Specifically for durable goods and also nondurable goods to lesser extent, the fact that we’ve seen supply chain pressures abating is a great sign and also for durable goods, specifically, semiconductor manufacturing capex has surged, and that is going to lead to a glut in semiconductors over the next few years, which will lift that major supply constraint, which is weighed on durable goods production.

New York Fed’s Global Supply Chain Pressure Index

Interestingly, we’ve seen the New York Fed’s Global Supply Chain Pressure Index, which is one of the best comprehensive indicators of what’s going on in supply chains that there is, we’ve seen that index show that supply chains have not only returned to prepandemic levels but indeed have become looser than at any time since the inception of the index in 1997. And so this captures product backlogs and delivery times and shipping costs. It’s a wide set of indicators that show that supply chains are in very good shape right now.

Wage Growth Has Slowed

Looking at the bottom chart: This shows the picture for wage growth. There’s actually a lot of different measures that are out there, and they each have their pros and cons. We track a composite of four main measures, and that shows that wage growth has slowed from a peak of 6% year over year in early 2022 to 5% year over year in the first-quarter 2023, and that’s been without a large normalization of the labor market, yet. I mean, hiring has pulled back, but it still has much further to go in our view. And so as employers start to normalize their hiring further over the next year, that will provide continued downward pressure on wage growth.

With that, I’m going to kick it back over to my colleague, Dave Sekera, to wrap up the presentation.

Mega-Cap Stocks Have Surged

Sekera: All right. Well, thank you very much, Preston. And of course, we can’t talk about the stock market without talking about what’s going on with the mega-cap stocks. I mean, just if nothing else because they do skew the market action and valuation. Taking a look here, what we’ve seen over the past quarter and actually year-to-date, the mega-cap stocks have surged higher, and at this point, I think a lot of them have probably run their course. So, taking a look at those that were rated 4 and 5 stars at the end of 2022: Pretty much all of them other than, I think, two have significantly outperformed the market. Of those, Bank of America, being in that financial-services sector, is the only one that is down thus far this year because of what we’ve seen going on in the banking sector.

And Berkshire Hathaway has lagged the market but, again, at an 8.2% return. I really don’t think that’s necessarily all that bad. But again, not too many of these are rated 4 stars anymore: only Alphabet, Berkshire, and Bank of America. The rest of these 3 stars and a couple of them also now moving into that 2-star territory.

At this point, six stocks that were on the list at the beginning of the year have dropped off, only three remain, no new additions this past quarter. But what we’re now seeing is going to be a pickup in the number of overvalued mega-cap stocks. So these are the ones that were rated 1 or 2 stars at the beginning of the year. We can see quite a few of these have substantially underperformed the market. You know most of them having actually negative price returned thus far this year. Couple of them having fallen enough that they’ve actually now moved into the 3-star category from the 2-star category. But it still leaves us with a pretty good list here of overvalued mega-caps. The list has now grown to 10 from only four last quarter. So it does have a couple of additions on here being Apple, Broadcom, Oracle, Home Depot, Merck, Coke, and Pepsi.

Fixed-Income Market Outlook

Let’s just wrap things up with a quick fixed-income market outlook. Bonds have had an OK year thus far this year, although I’d say those returns really had been skewed to what we saw in the first quarter, in the second quarter, probably most of them a little bit above, breakeven, although not that much. A couple of pullbacks here and there, but again, thinking about, what we expect going forward and thinking about some of the forecasts, from Preston from his economic point of view. We do think that while there is one more hike in the federal-funds rate, that we do expect that that’s going to be the last hike of this monetary policy tightening cycle. We would expect short-term rates in 2024 to start coming down.

While you can still hide in the short part of the curve and get pretty decent yield here in the short term, that’s going to run its course probably later this year and beginning of next year once the Fed and the market starts pricing in the federal-funds rate coming down. I know in the longer end of the curve, we do think that interest rates here, and I think the 10 year has recently gone slightly above 4% again, we think that those rates are probably either at their peak a little bit above 4% or at least probably going to be pretty close to being at their peak. So I do think now is a good time to start moving out on the curve, being able to start lengthening your duration, into longer-duration securities from that shorter end or middle of the curve that we had been advocating for before.

And then for those investors who are willing to take a little bit of added risk on, I do think that both the investment-grade and high-yield credit spreads, I think they’re reasonable. I don’t think that they’re necessarily undervalued. I don’t think that they’re overvalued at this point. But thinking through our outlook for the economy, while we do expect the rate of economic growth to slow, we’re not expecting a recession. In fact, we’re not even expecting any individual quarter with a contraction. I expect that the number of downgrades and the number of defaults in the corporate bond market will remain relatively low. And so I think that you are getting paid appropriately for the amount of credit risk that you’re taking in both of those markets today. You know, both of them offering pretty good yields for investors.

Morningstar US Corporate Bond Index

And then lastly, for those people that have an interest in the longer-term charts of what corporate credit spreads have looked like, this is the Morningstar US Corporate Bond Index, and again, that’s our proxy for the investment-grade index. So yes, the current spread is below that long-term average, although I’d note that long-term average certainly gets skewed higher by what’s happened with the global financial crisis in 2008, 2009, the Greek debt crisis in 2011, and then most recently, the pandemic. So I think if you were to strip out some of those exogenous activities that had happened, I do think that we’re still at pretty reasonable level in the investment-grade market and then similar for the high-yield market there as well.

With that, here are our disclosures. I’m going to make our compliance team happy, and I’ll leave this up here for a little bit for people to peruse. And while the disclosures are showing, I’d like to go ahead and pass things back to Susan. And Susan, if you wouldn’t mind going ahead and starting to compile some of those questions, and Preston and I’ll be happy to take what the audience has.

Growth Stocks vs. Value Stocks

Dziubinski: Thank you, Preston and Dave. We’ll move on to the Q&A portion of our webcast today. Let’s get right to some of these questions. Dave, this one’s probably for you. If economic activity isn’t cooling off as the Fed and the market expected, what might happen when it comes to growth stocks versus value stocks?

Sekera: I think the biggest concern there is what the Fed is going to do if that doesn’t happen. And so at this point, I know, our base case is we’re looking for one more rate hike and then that’s going to be the end of this monetary policy tightening cycle. However, if the economy does stay stronger, stays hotter for longer, I do think that that could concern the market, that we could see additional rate hikes from here, and of course, depending on how much those rate hikes go up and how long that they would stay at those elevated levels. I think the big concern would be: Would that potentially cause a recession? And depending on how high and for how long those rates are going to be up there, it could be a relatively deep or prolonged recession, so in that case I would actually think that would put a lot of pressure on the overall market. Now, having said that, I would expect value stocks to hold up better. So again thinking through our valuations, there’s a much better cushion there: value stocks trading at a 15% to 16% discount from our fair values where the growth stocks are much closer to fair value. And also I’d also be very concerned about a lot of those growth stocks that really have ramped up this past year, those especially that we think have run too far, too fast, you could certainly see some big pullbacks in that case.

“Big Seven” Concerns

Dziubinski: Let’s talk about that a little bit more, Dave. We’ve gotten some questions about how concerned should we be with the “Big Seven”? Are there reasons to be worried when so much of the markets return has been concentrated in so few stocks?

Sekera: I don’t think it’s necessarily whether or not we should be concerned. I think it’s more a matter of the valuation and what that means for investors going forward. If you were to go back to that slide where we show our valuations on those seven stocks, it’s more matter of: I expect returns in the second half of the year to probably be a lot more muted than what we saw in the first half of the year. There’s two parts to that. One: just the broad market was significantly undervalued coming into the year. We’re only at a 5% discount now compared to 16% at the end of last year. And then also with those seven stocks, it really had been the market driver until now. They’ve kind of run their course; from a valuation perspective, we just don’t necessarily see a lot more upside there. And in fact, we could see, some pullbacks: Nvidia and Apple being the two that, from a valuation point of view, I would be most concerned about seeing those sell off potentially in the second half of the year.

Morningstar’s Fair Value Estimates

Dziubinski: Now we’re getting several questions coming in about Morningstar’s fair value estimates. How we calculate them, does P/E have anything to do with it? And what do we mean by “margin of safety”? Dave, can you do a quick run through on that?

Sekera: Sure. So, margin of safety, I don’t know, I think maybe it was coined by Graham and Dodd, two famous professors that wrote the security valuation handbook decades ago, I’m not even sure when it was published. So I think they probably coined the term “margin of safety” and I think it’s been more popularized by Warren Buffett. But again, it’s just talking about how much of a discount you think a stock is currently trading in the marketplace versus its intrinsic valuation. And when we talk about “intrinsic valuation,” we do the full academic valuation methodology for each company we cover, we do have a discounted cash flow model. And when you think about what is the value of a stock, yes, there are a lot of different shorthand metrics or ratios that people might use to try and gauge valuation like a P/E ratio. But again that, to me, doesn’t necessarily tell investors much about intrinsic value. So again, the value of a stock is the present value of all of the future free cash flows that company is going to earn over its lifetime, discounted to today based on its weighted average cost of capital. And so then coming up with that is our intrinsic valuation and based on how much of a discount it may be trading in the marketplace compared to that present value is then that margin of safety.

Why Were Recession Predictions Wrong?

Dziubinski: Preston, a couple of questions for you. Just to reiterate: Is Morningstar’s position that there will not actually be a recession? And then as a follow up on that, what made predictions of a market recession wrong?

Caldwell: I think right now there’s about a 30% probability of a recession over the next 12 months. I think that one thing I’ve talked about is the binary question of will there or won’t there be a recession is not very important. It gets way too much airtime in the media because we’re already headed for a period of, I think, below-trend growth. I think 1.1% for 2024. So whether the final growth number is 1.1% or whether it’s 0% with a couple of quarters in negative territory that then is deemed a recession, that’s not a big of a difference between those two scenarios. It’s not night and day necessarily when you are in a recession. I think what is important is: What is the risk of a severe recession? And I think that continues to remain very low with the vulnerabilities in the economy not being anything on par with, say, the 2000s heading into the Great Recession. That kind of scenario is not in the cards, I think.

And OK, so why did many people who were forecasting, let’s say, a 75% probability of recession, which many were about a year ago, why did they get that wrong? I would say one thing is, again, they may not be wrong. We may still get a recession. I still think the probability is about 30%. It could just be that the (lags) with which monetary policy impacted the real economy at much longer than we would have anticipated. And so, I mean, we haven’t really had a purely Fed-driven recession anyway since the early 1980s. If you think about all the other ones, I mean the Fed has played a role but hasn’t been the main driver. So, we don’t have a lot of great data in terms of exactly how to estimate the timeline for when monetary policy impacts the economy.

So, there’s plenty of reason to think that it’s just going to be a lagged effect. As I mentioned, you know, the banking sector still has a ways to contracting their credit growth, and that’s going to weigh on the economy over the next year in terms of bank-loan growth slowing. Now, what I will say also is that we’ve also seen financial conditions remain fairly resilient in the capital markets. For example, the yield curve has inverted, with the 10-year Treasury yield about 100 basis points below the federal-funds rate and that’s actually stimulatory for the economy. I know a lot of people think about an inverted yield curve as being a bad thing, but the fact that the 10-year Treasury yield is at 4% right now and it’s not at 6% above the Fed-funds rate, that stimulates more credit growth than would be occurring otherwise. So that’s helped to cushion the impact of higher federal-funds rates.

And also obviously the stock market as we’ve been talking about today has done quite well over the last year after hitting a trough in 2022. That’s helped to keep consumer spirits up and help the economy to avoid a recession. We also finally, sorry, we haven’t really seen much knock-on impact from the direct impact of Fed-rate hikes. You know, Fed-rate hikes have curtailed housing activity, but for example, the homebuilders haven’t really cut back their employment at all. Employment in housing-related industries has remained resilient, and so even as the rate hikes have affected some industries, those industries haven’t really passed on the effects to other parts of the economy, although that will probably change somewhat over the next year.

Should You Invest in Wide-Moat Stocks?

Dziubinski: Dave, let’s talk a little bit about, Preston mentioned that it’s low probability of an actual recession, but there will be an economic slowdown. Viewers asking, in light of that, if we do expect a slowdown in growth, wouldn’t wide-moat stocks be the place to be? But they look, like you said, a little closer to fairly valued today than say no-moat or narrow-moat stocks, but would wide-moat stocks still be the better play here?

Sekera: Well, like anything else, that always comes down to valuation. In this case, if we do have, some market selloffs, typically I expect those high-quality stocks probably sell off less to the downside than those companies, like a no-moat rated stock that doesn’t have long-term competitive advantages. So yes, from the perspective of for a similar company, for a similar valuation, or trading at a similar price/fair value, I would expect that the wide-moat stock or narrow-moat stock would probably sell off less than what I would expect a no-moat stock. But from a broader perspective for our entire coverage level, because the no-moat category is trading at such a large discount, I do think that that gives you much more of a cushion to the downside. So again, it’s always really going to depend on how you’re looking at it from an individual company or individual sector level as compared to a category level.

International Interest Rates

Dziubinski: Could lowering interest rates, which we said Morningstar expects the Fed to begin to do sometime in 2024, could lowering interest rates make the investment money move out of U.S. markets and go abroad somewhere with better interest rates?

Caldwell: No, I don’t think so. Because, I mean, compared to a lot of economies, the interest rate that you will receive in the U.S. is still going to be fairly attractive compared to where it was at before the pandemic, for example. If you look at, let’s say, the U.S. compared to many emerging markets, that’s the case. Now there is a chance for nominal interest rates to be higher in Europe than the U.S. for a period of time if their inflation problem lingers longer. However, as an investor, really, what you care about are real interest-rate differentials because if inflation is higher in the eurozone, you would also expect the euro to depreciate. And so I wouldn’t expect investor capital to chase after that yield differential. Really, I don’t think the U.S. is looking at worse real interest rates compared to other developed economies, which continue to be afflicted by aging demographics and lower productivity growth. Some of the factors that have been secular drivers of weak real interest rates in the long run.

Utility Stocks Valuation

Dziubinski: OK. Last question this morning or this afternoon is regarding sectors. Dave, a viewer wants to know what our take is when it comes to valuation of utility stocks right now. And then what are your best stock sectors in terms of valuation? I know you covered that in the presentation, but maybe you could just reinforce that.

Sekera: The viewer can always go back and watch the replay here and go back to the page that shows all the individual sector valuations, but the one that is still the most undervalued is going to be the communications sector. So a lot of opportunity there. You know, Alphabet still being undervalued again, that has a huge skew because of the size of its market cap. Meta, at this point, we think is fairly valued now that the stock has doubled thus far this year. But again, I do like a lot of those traditional telecom and media names. You know those that trade at very large discounts and have big dividend yields, I think, are attractive for the second half of the year. And then a lot of the cyclical sectors, we think, are still going to be the best areas. So again thinking through there, we do have the financial-services sector and the real estate sector, although I do think in the real estate sector, you do need to be a little bit choosy and I’d probably still steer away from any of those REITs that focus on the urban office space.

Dziubinski: Thank you, Dave and Preston. And thank you, everyone, for joining Morningstar’s third-quarter 2023 U.S. stock market outlook webinar. And have a great day.