Are We There Yet?

Mark Luschini, Chief Investment Strategist

The title of this monthly submission is a common refrain heard by those familiar with driving a long distance with young children in the car. In some ways, the widely held (and likely accurate in our estimation) view that the U.S. will encounter a recession in the next 12 months is similarly frustrating for investors in the stock market.

Recession Talk Persists

It seems like a recession’s potential arrival has been talked about for the better part of a year, but one has yet to occur. Certainly, there are growing signs that the economy is softening. However, many other data points suggest it is not so weak as to declare that a recession is imminent.

That standoff, among other things such as inflation and the Federal Reserve’s fluid monetary response to it, is trapping the broad stock market from mounting a sustainable advance. At the same time, it also keeps the market from succumbing to the large drawdown that would be expected if a measured slowdown in the economy drove a collapse in corporate earnings.

How this draw resolves will probably break the S&P 500 Index’s roughly 400-point trading range that has bound the stock market since the beginning of the year. In the meantime, we advocate staying the course with an admission that a cautious bias weighs on our asset allocation and sectoral positioning. Those views can be seen in detail by way of sister publications from the Investment Strategy Group including Marketvane Monthly, chart packs, and sector strategy reports.

Consumer Impact on the Economy

It bears repeating: the key to identifying the underlying strength of the economy is taking a litmus test of the consumer. Since household consumption is responsible for approximately 70% of the economic activity in the U.S., a view about consumers’ wherewithal and sentiment toward spending is important.

Monthly surveys from the University of Michigan and the Conference Board are working higher from their pandemic lows, but admittedly have not yet fully recovered to levels seen before the COVID-19 outbreak.

While still somewhat depressed, spending continues to grow at a slightly above-trend pace, but it has shifted from buying goods to travel and leisure-related activities. In addition, even as the abundant savings that accumulated during the pandemic has been exhausted by those in the lowest-quintile-income cohort, it remains north of $1 trillion distributed across the other four income quintiles—a group that in the aggregate accounts for roughly 91% of the spending in this country.

The Jobs Market Another anecdote that supports the notion that the consumer remains sufficiently emboldened to spend is the statistic found inside the monthly Job Openings and Labor Turnover Survey (JOLTS). The so-called quits rate—a measure of those leaving their employer to join another—offers insight as to the confidence employees have about the labor market in general, as well as their role in it. In its most recent release, that figure stood at 2.6%, a level down from a peak of 3.0% last reached in April 2022, but still well above the series trend over the last two decades. The interpretation is that employees feel reasonably secure in their employment and usually switch jobs only if they are available and relatively promising as far as promotions and pay.

Bottom line: the economy can trundle along until such time cracks begin to emerge in the labor market and consumers start to meaningfully retrench to shore up their finances. At that point, we will chart a course to adapt to a landscape that could look much different going forward than it does now.

Summary

Indeed, the odds of a recession are heightened but we’re not there yet. The Federal Reserve has raised rates quickly and to a level that should work to slow demand and curb inflation. In addition, the tightening of credit conditions following the recent banking turmoil could further curtail growth. A combination of these factors may very well thwart the pace of economic activity and lead to an outright contraction. However, until such time the evidence of a dire outcome is more persuasive, we remain open-minded to the prospect that the recession’s onset is postponed, or better yet, averted.

Complications in Policy

Guy Lebas, Chief Fixed Income Strategist

Federal Reserve policy is supposed to be simple: the FOMC, led by the Fed Chair (currently Jay Powell) tries to set monetary policy to achieve maximum employment and stable prices. These qualitative metrics have slowly grown into semiquantitative goals—the Fed’s estimate of maximum employment is about a 4% unemployment rate and its explicit inflation target is 2%—through which policymakers raise and lower interest rates to try and hit.

How Fed’s Methods Changed

The tools the Fed formerly used to manage to their mandate were equally simple, although today, not so much. Overnight interest rates were mainly the province of banks lending to other banks. Then, the Fed would lend or borrow into those markets, and interest rates between banks would move based on the Fed’s supply or demand. Later, the Fed began announcing the level of overnight interest rates, which caused markets to “snap to” the Fed’s rate.

In the 1990s, in addition to announcing the level of overnight rates, the Greenspan Fed began issuing statements describing the reasoning behind each decision, a precedent which led to more transparency and today’s focus on “forward guidance”—internal predictions of what the Fed was likely to do next.

Although monetary policy has become more transparent, the simple methods of implementing it have become increasingly complex. Whereas the pre-1980s Fed acted on overnight rates by buying and selling, today’s Fed has to do a lot more to get its policy plans to stick.

One reason is that there are many more types of overnight money markets today than in the 1980s. While the interbank markets are significant, there are much larger “repo” markets in which a range of participants lend and borrow overnight, administered markets via which borrowers or lenders transact directly at the Fed, and also international “cross-currency” markets. If the interest rate in any of these markets diverges significantly from the Fed’s target, policy gets “leaky” and might not reflect policymakers’ intent to manage growth and inflation.

Markets Work through Complexity

One notable recent example stems from big inflows to money market funds (MMFs) since the collapse of Silicon Valley Bank in March (presumably corporations are understandably getting cautious with cash management). Some of these funds are required to buy ultra-short-term Treasuries and invest in only Treasury-secured repo loans.

Chart 1: Wide Spread Between 1m Treasury Bill & Fed Funds Rate Signals Market Plumbing Stress

Not surprisingly, the interest rates on 1-month T-bills and Treasury repo have fallen below the Fed’s rate target. Meanwhile, other banks are raising interest rates to keep their deposits from heading out the door, creating a sort-of convergence in bank and MMF interest rates.

This example goes to show that Fed policy in 2023 is messy and complicated. However, it also highlights that the market is, sometimes in unexpected ways, self-correcting. Many market participants, ourselves included, have argued that the Fed has raised interest rates too far in a way that has created financial fragilities; now that some fragilities are out in the open, money is finding its way into areas of the financial system that effectively force market interest rates lower.

What used to be a simple matter of lowering or raising interest rates is more complicated now than ever, but markets continue to provide signals that additional Fed rate hikes are more harmful than helpful.

The Other Six Months

Gregory M. Drahuschak, Market Strategist

May begins with the hope that the equity market successfully can navigate the traditionally lackluster May-through-October period. Depending on negotiations in Washington D.C., however, the debt-ceiling debate and other factors could make this six-month period more difficult than usual.

Historical Averages for May–October

It is well documented that November through April, on average, produces better results than the May-through-October period. The key phrase, however, is “on average.”

Chart 2: Average Monthly Percentage Results S&P 500 Index 1950-2023

Since 1990, the market has had to navigate these six-month periods 33 times, eight of which were in the third year of the presidential election cycle. The average for all 33 years was an S&P 500 Index gain of 2.15% from May through October, but 6.65% in the November-through-April periods. The S&P 500 was up in 23 of the relevant May-October intervals and in 25 of the November-April periods.

Table 1: S&P 500 % Changes — Third Year of Election Cycle

The results change when only the third years of the election cycle are considered. In the May-October periods, the S&P 500 averaged gains of 4.18% versus 3.3% in the November-April periods.

Debt Ceiling, Earnings, and Other Factors

The debt-ceiling talks could be a major impediment to near-term stock market gains. The current debt-ceiling impasse closely resembles conditions in 2011. Then, as is true now, one part of Congress was demanding spending controls in exchange for an increase in the debt ceiling.

Chart 3: S&P 500 Large-Cap Index, June–September 2011

An 11th-hour agreement in 2011 avoided an outright default on U.S. debt. Nonetheless, Standard & Poor’s lowered the credit rating of the United States from AAA to AA+, and although an agreement was reached, the S&P 500 fell about 17% between late July and mid-August of 2011.

Chart 4: 2023 S&P 500 Earnings Estimate

Corporate earnings are another area of concern. The 2023 S&P 500 earnings estimate has fallen in 30 of the previous 33 weeks to $218.21, which is 0.47% below the 2022 final and 11.7% below what was expected when 2023 estimates were first available. Of the 11 S&P 500 sectors, only five (Communication Services, Consumer Discretionary, Consumer Staples, Industrials, and Utilities) are expected to produce year-over-year earnings gains.

Earnings expectations for eight sectors were lower at the end of April than they were on the first day of 2023. As a result of weakened earnings expectations, the market priceearnings ratio based on 2023 full-year earnings is relatively high at nearly 19. Some market participants, however, argue that the market at this valuation is looking beyond the current earnings slump. Nonetheless, this leaves little room for additional earnings deterioration.

Chart 5: Year-to-Date 2023 Sector Percentage Changes

Market’s Remarkable Resilience

Despite all of this, the market’s resilience has been remarkable. The recent bank problems offered many reasons for the S&P 500 to fall under the low of the 3,800- 4,200 range it has been trapped in for a year. Instead, by the middle of April, the S&P 500 was more than 300 points above the bank-induced low in March, and performance for April (up 1.46%) ended only four basis points below the average for all Aprils since 1950.

The equity market is likely to break the upper boundary of the recent trading range well in advance of corporate earnings prospects turning up and before GDP growth is more robust. For now, however, maintaining a temporarily cautious approach appears to be wise.