The S&P 500 Index rebounded 6.4% last week, with its best day since 2020 on Friday, as fears of an aggressive Federal Reserve (Fed) receded.
The rebound in stocks last week coincided with Fed Chairman Powell’s Congressional testimony, which acknowledged that getting inflation under control could lead to a recession, while Friday saw consumer expectations for inflation dip from the preliminary read earlier this month (the preliminary reading influenced the Fed’s recent more hawkish stance). All of this suggests that inflation and the Fed’s response to it remains the driving force for the market.
While incoming data remain consistent with a slowing economy and a higher risk of recession, our base case remains that the economy avoids recession this year–acknowledging heightened uncertainty.
Many of the factors causing high inflation are out of the Fed’s control, including COVID-related supply chain problems, food and energy inflation, and the Ukrainian crisis. Supply-chain problems are slowly getting fixed while abnormally strong demand for hard goods during the pandemic is falling, along with price pressures. A return to the pre-pandemic labor force participation rate would help alleviate wage inflation pressures. U.S. energy independence helps offset the pain consumers are feeling at the gas pump, unlike previous oil price spikes that were associated with recessions. Any potential ceasefire in Ukraine would ease geopolitical fears.
Due to the factors mentioned above, the consensus is calling for inflation to fall in the back half of the year and this could allow the Fed to ease off its current aggressive path of rate hikes, which would lower recession probability.
Incoming Data Consistent with Slower Growth
The Conference Board’s Leading Economic Index fell for the third consecutive month in May, led by falling equity prices, weaker construction activity, and sliding consumer expectations. Unemployment claims are also trending higher. The four-week moving average rose by 4,500 to 223,500. Although still historically low, that’s up 53,000 from the April 2 trough.
The S&P Global Flash U.S. Composite PMI (a preliminary, but timely, business survey) fell 2.4 points in June to 51.2 (readings above 50 indicate expansion, below 50 indicate contraction), a five-month low. Services declined 1.8 points to 51.6, below the consensus for unchanged. Manufacturing also swooned more than expected, dropping 4.5 points to 52.4—the lowest reading in nearly two years versus a consensus of 56.1.
While economic momentum continues to slow, we note that the U.S. economy has healthy underpinnings. Outside of high inflation, we do not see major economic imbalances that have been associated with previous recessions. Consumers are still healthy, supported by a strong labor market (which the Fed is actively trying to cool), excess savings of over $2 trillion, and pent-up demand for housing, autos, and travel and leisure.
History of Previous Bear Markets
Given that we recently entered bear market territory with recession concerns, we continue to field questions on the length and depth of previous bears. Of the 10 bear markets of the last 60 years, defined as a peak-to-trough decline in closing prices of at least 20%, half lasted between one-and-a-half and two years, while the remainder, excepting the current unfinished one, have been relatively sudden events, persisting for less than six months. Drawdowns have ranged from 20% to 57%, with average and median losses of 36% and 34%, respectively.
We note the 57% drawdown was due to 2008’s great financial crisis, driven by over-indebted consumers and banks. Today, the banks are much better capitalized as evidenced by the recent results of the Fed’s rigorous bank stress tests, which all 33 banks passed. Consumers are also much healthier as noted above.
Timing bear markets and recessions are very difficult while the economy spends the majority of time in expansion. We continue to recommend investors stick with their long-term investment plan.
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