Chairman Powell stated that rates are now well above estimated levels that restrict economic activity. While underlying economic demand remains sturdy, which helps justify higher rates, monetary policy acts with a lag. Restrictive monetary policy and banking system strains that will further restrict the flow of credit, coupled with many other leading indicators that suggest economic weakness ahead, have us remaining cautious on our outlook for stocks.
Current Indicators Consistent with Economic Growth
We recently received several important indicators on the state of the economy including April’s business surveys, first-quarter GDP, state economic indicators, and personal income and spending. These indicators remain consistent with an expanding economy.
The ISM Services PMI (a monthly service sector business survey) ticked up in April, indicating a modest expansion in services activity. The net number of industries reporting growth increased to 11 from 8 in the prior month, the most since October. Both the level of the PMI and industry breadth are consistent with continued economic expansion, albeit at a subdued pace.
While the ISM Manufacturing PMI picked up, it stayed in contraction territory for the sixth consecutive month. The uptick does indicate a slower pace of decline in manufacturing activity, but industry breadth remained narrow. Of the 18 ISM industries, only five expanded, fewer than half for the seventh consecutive month, and consistent with a decline in manufacturing output growth.
The GDP report showed the economy grew at a 1.1% annualized rate in the first quarter (Q1). It was a sharp deceleration from the 2.9% average growth rate in the second half of 2022, driven by a steep drop in private inventory investment. Without the inventory correction, growth would have been a 3.4% annualized rate, as reflected in final sales. This is above the 3.1% average growth rate historically and shows that under the surface, final demand is still running strong—helping justify higher interest rates.
While sources of consumer strength such as excess savings from the pandemic stimulus and easy access to credit may be waning, consumer demand was supported in Q1 by stronger income growth. Disposable personal income shot up at an 8.0% annualized rate, the most since Q1 2021, reflecting increases in compensation (which is related to the strength of the labor market) and government social benefits (including an 8.7% cost-of-living adjustment that took effect in January), as well as lower personal income taxes. With income and consumer spending growing at solid rates, calls for recession are premature, despite many leading indicators pointing to economic weakness down the road.
The Philly Fed state coincident indexes are also consistent with an expanding economy, with increases in 49 states in March. The average monthly change across all 50 states was 0.4%, the most in a year, and double the historical average of 0.2%. Similarly, the U.S. coincident index rose 0.3% from the prior month, also above its historical average of 0.2%. While its y/y change has eased to 3.8%, it remains higher than at the start of all recessions back to 1979.
Inflationary Pressures Remain Sticky
PCE inflation (a favorite Fed inflation gauge) fell to 4.2% y/y in March from 5.1% in February, the slowest rate since May 2021. Core PCE inflation showed less progress, ticking down to 4.6% from 4.7%. Closely watched by the Fed is services ex-energy and housing inflation, or the super-core, which edged down to 4.4% from 4.7%. This metric remains stubbornly high and suggests that the broader core PCE inflation will have a hard time reaching the Fed’s 2.0% target.
Profits Better Than Low Expectations
With 64% of S&P 500 companies having reported, 70% are beating Q1 earnings (vs. 67% avg. last 4Qs). Earnings have materially surprised to the upside by 6.5% (vs. 1.0% on avg. through past 4Qs). Since the beginning of earnings season, the Q1 consensus earnings estimate has been revised up 3.9% to $52.40 (-4% y/y) and 2023 EPS by 0.5% to $220.46 (+1% y/y). While better than expected, poor earnings growth presents a headwind for stocks, which are ultimately supported by higher earnings.
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