What recession? Because stocks are rising despite warnings of doom and gloom

It’s been a hell of a year so far. Three regional banks went bankrupt, the US came close to defaulting on its debt for the first time in its history, and the Federal Reserve continued to raise interest rates aggressively.

But despite all of that, the stock market rallied in the first half of the year. What does it give?

A lot has to do with the economy.

Despite widespread expectations that the US could head into a recession this year, the economy has proven to be much more robust than many on Wall Street had anticipated.

There are other reasons as well. Artificial intelligence has helped lift the tech sector, for example.

All of this meant that the three major indices ended the first six months of the year in a bull market, meaning they were up more than 20% from their most recent lows.

But all is not as rosy as the numbers seem to show and there is much uncertainty about the path forward.

Here’s a look at how the markets are doing and what could be in store for the rest of the year.

Why the stock markets gained so much

There has been a notable shift in sentiment since the start of the year.

In January, economists and policymakers warned of a potential recession, and that made investors extremely wary, according to Savita Subramanian, head of US equity and quant strategy at Bank of America.

“We spent basically a year worrying about this recession and then worrying about all these potential calendar events, like the debt ceiling,” he says. “And over that time period, investors have become increasingly cautious.”

They avoided risky bets and steered clear of cyclical stock companies whose performance tends to correlate with economic booms and busts.

But the economy confused many forecasters by proving to be stronger than expected and this has helped markets weather difficult events such as the turmoil that engulfed the banking sector with the collapse of lenders such as Silicon Valley Bank.

What made the economy so resilient? There are a number of factors. The job market has remained strong, despite some high-profile layoffs. The construction sector has moved on, while other companies in areas such as retail have been reluctant to lay off workers for fear of not being able to re-hire them.

And consumers continued to spend despite high inflation, splurging on things like traveling and eating out, while cutting back on other spending.

It’s not just the US economy, but other countries have also done better than expected, helped in part by lower energy prices and the easing of pandemic restrictions in China.

“Perhaps the biggest surprise over the past six months is that we’ve actually seen a pretty strong recovery in global growth,” says Paul Mielczarski, head of global macro strategy at Brandywine Global Investment Management, a boutique investment firm.

But it’s not all rosy

Despite the market’s strong gains, one troubling detail: The stock market’s gains have not been large.

It’s usually a sobering Wall Street signal.

Indeed, much of the recent rally in the markets can be attributed to the enthusiasm for AI following the debut of ChatGPT.

This has led to a soar in the shares of companies with AI-related businesses, including chipmakers Nvidia, AMD and Qualcomm.

But as the dot-com bust in the early 2000s demonstrated, it can leave the broader market vulnerable if enthusiasm for AI suddenly reverses.

This week, later The Wall Street Journal said the Biden administration is considering new export restrictions to China on chips used for artificial intelligence, those companies’ stocks have suffered.

For investors to grow more confident, the gains seen in AI will need to spread to other types of companies, which would more reflect broader optimism about overall market prospects.

Bank of America’s Subramanian is optimistic that this could start happening in the second half of this year.

“We could see big gains in the broader market outside of those big tech names,” Subramanian says.

Subramanian attributes his optimism to hopes that any downturn could prove relatively mild, which could boost the prospects of other industries that haven’t gained as much as tech.

But there are still lingering concerns for banks

Mid-year, there are also fears of a resurgence of the banking turmoil.

After the implosion of Silicon Valley Bank, Signature Bank and First Republic Bank, many of the smaller regional banks’ customers moved their money to larger institutions.

Many of these lenders have also lost deposits which are, of course, vital to a bank’s pursuit of high-yield investments, such as money market funds.

Recently, outflows from smaller lenders have leveled off. But analysts are watching closely for signs of heightened distress, and Wall Street will have a better idea of ​​how these banks are doing when lenders report their latest gains starting this month.

They are also paying attention to another consequence of that collapse.

Since then, credit conditions have tightened, meaning banks are becoming more cautious in making loans to consumers and businesses.

If this continues, it could impact economic growth.

Furthermore, banks are still vulnerable to high interest rates because they can erode the value of many lenders’ vast bond portfolios.

And other challenges are ahead

Despite the gains, some of the big trends in the economy haven’t necessarily changed.

Inflation has come down but remains stubbornly high and the Federal Reserve has clearly signaled that it will need to continue raising interest rates. This means that borrowing costs across the economy will continue to rise, so mortgages and loans will continue to get more expensive.

It takes some time for higher rates to filter through the economy, so while recession fears have eased somewhat, they haven’t completely disappeared.

“We are still in the most aggressive monetary tightening cycle since the early 1980s,” says Brandywine Global’s Mielczarski. “And I think we’re really going to see the full impact of that tightening cycle in just the next 12 to 18 months.”

Therefore, the economy could very well avoid a recession this year, but there is still the possibility of a downturn in 2024, which would mean many of the stocks’ gains could still reverse.