9 Market, Economic Predictions for the Rest of 2023: Schwab

2. Get ready for lower earnings.

Earnings estimates for this calendar year are rising, but that trend may not be what it appears, Sonders suggested.

“There’s been a lot of talk about how 2023 calendar year estimates have been going higher. That’s true but it’s solely because of better-than-expected Q1 earnings that are now in the books," she said.

"Actually estimates for Q2, Q3 and Q4 have been trending down, it’s just the overall year gets that lift because of the outperformance versus consensus in Q1.”

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3. 'Extreme' optimism levels, like today's, tend to predict a flat stock market.

Asked whether the stock market has become "frothy," Sonders responded: “I think there’s a bit of FOMO going on this year, which seems to be the most apt acronym for some of these big moves up in the market," referring to fear of missing out.

Sentiment measures indicate the stock market just popped into the “extreme optimism zone,” when gains tend to be flattish, after coming out of what historically has been the "best zone," when sentiment is coming off lows like last October's, when the market was oversold, according to Sonders.

Sentiment is an imperfect measure, however, and shouldn't be used to time the market, she said, noting the market was "frothy" and had FOMO for a few years in the late 1990s.

In its formal midyear outlook posted on June 15, Schwab cited investor sentiment as a "budding risk" heading into the second half. If rising optimism becomes excessive, the outlook could shift to more volatility and weakness, according to the report.

"We will be keeping a close eye on sentiment conditions as we transition to the second half," the firm said.

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4. Market averages don't predict anything.

Pundits like to point to average stock market performance after a given event, noted Liz Ann Sonders, Schwab's chief investment strategist, who cautioned against basing expectations on those historical averages.

Citing averages for past S&P 500 index movements following final rate hikes in Federal Reserve tightening cycles, Sonders called the statistics "a perfect characterization of the phrase I love so much about analyzing data, which is, ‘Analysis of an average leads to average analysis.’”

The range of experience over the past near-century when the Fed finishes raising rates is so wide that it flattens out the average, she noted, with the market doing well or poorly in any given year.

By definition, what’s happened in those individual circumstances “doesn’t look anything like the average," said Sonders, who also noted the small sample size — only 14 rate-hiking cycles — makes the average even less reliable.

Beyond that, she added, “There are so many other forces that drive market behavior, not simply where you are in the Fed cycle.”

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5. Fixed income looks promising.

Schwab Chief Fixed Income Strategist Kathy Jones cited what she considers "a pretty good environment" for fixed income.

Fixed income yields are at their highest levels in many years, and year to date every fixed income category that Schwab follows has had a positive total return, which represents income plus or minus price change, she said.

Schwab generally looks to core bonds — Treasury’s and other government securities and investment-grade corporate and municipal bonds, as well as agency bonds — for the bulk of its portfolio construction, as they offer the lowest risk and volatility, Jones said.

The firm likes the idea that investors can take a core portfolio, build out a 4.5% to 5.5% income stream and lock it in for five to seven years without much default risk. While they like investment-grade corporate bonds, they're wary about lower-quality fixed income, she said.

This is a good opportunity to extend duration and lock in cash flows for the next five to seven years , said Jones. “This is the best environment for that that we’ve seen in almost two decades.”

For those willing to take on more risk for potentially greater returns via more aggressive credit products, Jones cited emerging market and high-yield bonds and preferred securities. The firm is a little more cautious on high yield, though, because defaults likely would pick up in an economic downturn, she said.

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6. The AI stock rally isn't what it seems.

While interest in artificial intelligence appeared to drive this spring's market rally, Sonders suggested something else was happening.

AI played a role in the mega-cap tech stock rally, but Sonders sees those stocks' performance as directly tied to Silicon Valley Bank's fall.

“I think that was as much a driver of this as AI. I think of AI as a bit of a kicker because AI is not new … I think the real push was driven by liquidity concerns tied to the banking crisis and that caused a lot of money to just sort of snuggle up to those tech-as-defense kind of names," she said.

In terms of S&P 500 activity this year, the investment strategist said it's not unusual for larger-cap stocks to drive outperformance. “What makes the recent environment abnormal is the significant underperformance by the remainder of the stocks, call it the bottom 493” stocks in the index, she said.

“It’s not just the outperformance up the cap spectrum, it was the dramatic underperformance everywhere else that became a risk factor," she said.

Schwab noted the market rally has broadened some lately, with about 20% of S&P 500 stocks outperforming the index, and said further broadening would bode well for the market.

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7. The Fed will take a breather but will keep tightening.

The Fed seems to be transitioning from the rate hike to rate hold phase and isn't yet at the recalibrating and lowering rates phases, according to Jones.

There’s enough belief that the process has gone pretty far and is working so that they can take a moment to reassess and look forward, and then try to time out the cycle, she said.

The central bank seems to feel inflation is coming down and the economy has slowed, but the economy just came through the bank failure "incident," she noted, "and I don’t think that the Fed was inclined to trigger another incident right away and felt it had the room to kind of wait it out for a little bit longer while still signaling, 'Yeah we’re still in tightening mode.'”

The Fed continues to tighten, allowing up to $95 billion a month in bonds to roll off its balance sheet, and expects to do so for the next couple of years, Jones noted.

It may continue this tightening even if it shifts to lowering rates, which Jones called an unusual and questionable policy.

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8. The economy is in a ‘rolling recession.’

Sonders reiterated Schwab's belief that the economy has been in a "rolling recession" with different sectors experiencing weakness or strength at various points. Housing may be in a recovery mode now, she said, noting that strength and stability, like weakness, can roll through the economy.

The Leading Economic Index has contracted for 14 straight months and is down 10% from its peak 16 months ago, according to Schwab.

“We know pockets of the economy have suffered recession-type contractions," said Sonders. It's unclear, however, whether the National Bureau of Economic Research will officially declare that the U.S. economy has entered one.

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9. International stocks look good.

Schwab finds non-U.S. stocks appealing, citing more attractive valuations and faster earnings growth, even though the firm recognizes that an AI stock surge could give U.S. equities a further advantage.

The bull market has seen broader support in international markets than in the U.S., Jeffrey Kleintop, the firm's chief global investment strategist, noted. And valuations in developed non-U.S. markets are below 20-year averages, while U.S. stocks are higher, he said.

Although Japanese stocks recently hit a 33-year high, they might continue to surprise investors, he said.

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