The economy and stocks faced significant headwinds in the first quarter, including high inflation readings, the Federal Reserve beginning a rate-hike cycle, the Ukrainian crisis, and persistent impacts from the pandemic, including China’s recent lockdowns.

All of this led to commodities outperforming in the first quarter with a return of 26%, driven by higher energy, food, and raw material prices. Large-cap stocks finished down 4.6%, with higher interest rates now a headwind for valuations while high inflation is raising concerns for consumer spending and earnings.

Market concerns are now focused on the recent yield curve inversion. However, we think it is too soon to get bearish on the economy and stocks. We discuss the recent history of inversions and the impact on stocks below.

Recent Yield Curve Inversion

A yield curve inversion occurs when short-term interest rates move higher than long-term rates. The yield curve between 2 and 10 years inverted last week, while the 5- to 10-year portion had already inverted. However, not all of the curve has been flattening or inverting. The short end (using the 3- month to 2- or 10-year Treasury) remains relatively steep.

Yield curves invert close to the peak of an economic cycle, and after a peak there is inevitably a slowdown or recession. Consequently, talk of recession intensifies when the yield curve inverts.

It’s important to note that an inverted curve, no matter the maturities involved, is not very good at predicting the timing of recessions. Historically, recessions follow inversions, with long and variable lags. There have been nine 2- to 10-year yield inversions since 1965, with the median lead time to recession of about 20 months. In addition, stock prices tend to appreciate between curve inversions and recessions—suggesting that it doesn’t pay to be overly pessimistic as soon as the curve inverts.

The recent flattening has been caused by expectations that the Federal Reserve will raise interest rates too high in its inflation fight and that this will lead to a recession. Studies show that the 2-year to 3-month Treasury yield is statistically best at predicting recessions. Importantly, this part of the yield curve remains relatively steep. These conflicting yield-curve signals suggest to us that it is too early to make a recession call that would impact corporate profits and stock prices.

Recent History of 2- to 10-year Yield Inversion and Stock Returns

S&P 500 returns have typically been positive in the two years following yield curve inversion. There have been nine instances of a 2- 10-year yield curve inversion since 1965, most recently in August 2019. The S&P 500 has returned a median of +2% in the subsequent 3 months, +3% over 6 months, and +9% over 12 months. This pattern reflects the lag between yield curve inversion and the start of recession, during which equities typically continue generating positive returns.

Economic Fundamentals Consistent with Further Growth

At the beginning of every month, we get important readings from the labor market and manufacturing business surveys. These readings remain consistent with further economic growth with little sign of a near-term recession.

While the ISM Manufacturing PMI (business survey) continues to show moderating factory activity, it remains consistent with continued expansion and corresponds to 2.9% annualized economic growth, as estimated by the ISM. The Philly Fed State Coincident Indexes increased in 47 states in January, decreased in two, and were steady in one, also consistent with a broad-based expansion across the country.

The labor market continues to head toward maximum employment with March’s nonfarm payrolls up 431,000 and the prior two months revised up by 95,000. The unemployment rate fell to 3.6% from 3.8%, bringing it close to the pre-pandemic trough of 3.5%. Initial unemployment claims confirm this labor market strength with claims last week at 202,000, still near the lowest since 1969. Meanwhile, job openings remained near a record high at 11.3 million. This labor market strength, coupled with stubbornly high inflation, suggests the Federal Reserve will continue raising interest rates in the coming months.




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