President Joseph Biden announced his reelection campaign for president this week, even though 44% of registered Democrats say the 80-year-old president is too old to run. Biden’s current leading Republican rival, Donald Trump, who is 74 years old, is not supported by 34% of registered Republicans. Although Biden’s announcement could be the first step toward a rerun of the 2020 presidential election race, the political polls indicate it is a scenario most Americans do not want to see. Still, a lot can happen in the next 18 months and the early leaders do not always make it to the finish line, particularly since both of these candidates are hampered by legal issues and Congressional investigations. All in all, we do not expect the presidential election to impact the equity market this year, or any time prior to when the parties confirm the selection of their candidates and their platforms at their respective national conventions.

Watch Over the Dollar

However, domestic politics is not tabled. The pressing political issue on the horizon is the all-important debt ceiling and this could prove to be more serious than any election outcome. Treasury data for the days following the April 18^th deadline when most Americans file federal income taxes, suggests that the tax windfall for the Treasury is falling short of expectations. This shortfall could have several sources. There is a postponement of the tax filing deadline for disaster-area taxpayers in California, Alabama, and Georgia from April 18 to October 16.

In addition, the Congressional Budget Office forecasts that capital gains tax receipts could be as much as 17% lower on a year-over-year basis. This is directly due to the performance of the stock market in 2022 versus 2021. Nevertheless, the tax shortfall has major implications for the debt ceiling debate on Capitol Hill. Most economists were expecting the debt ceiling standoff to take place in August; however, it may become an emergency as soon as June. Failure for both parties to come together to address the debt ceiling and spending would be a disaster. The dollar and US Treasury securities have always been the world’s global currency and the world’s safe-haven investment. To change that would weaken not only the US economy, but the global financial balance that has existed for decades. And this comes at a time when the dollar is already under pressure related to challenges from China, Russia, India and Brazil, countries that have been pushing for settling more trade in non-dollar units. Even French President Emmanuel Macron has recently warned against Europe’s dependence on the greenback. A French multi-energy conglomerate, TotalEnergies SE (TEF – 58.31 €) and China’s national oil company, CNOOC Ltd. (12.42 HK$), recently settled a major liquified natural gas transaction in the yuan. According to Bloomberg, Malaysia has initiated talks with China on forming an Asian Monetary Fund in a bid to decouple from the dollar. A weaker dollar could have many ramifications, but the most immediate one would be higher inflation.   

Earnings Season

Meanwhile, the first quarter earnings season is filled with surprises. First Republic Bank (FRC – $8.10) plunged nearly 50% after reporting that more than $100 billion in deposits left the bank during the quarter. Deposit flight has been at the center of investor concerns as clients continue to move capital out of regional banks and into money market funds where higher returns are available or to larger ‘too-big-to-fail’ institutions. However, First Republic is not the only bank suffering from deposit flight. The decline in commercial bank deposits reached $979 billion in mid-April, and only 25% or $251.8 billion exited the banking system since, or due to, the March banking crisis. See page 8. In short, the banking system has been suffering from disintermediation since the Federal Reserve began to raise interest rates a year ago. This trend is apt to continue throughout the year. And in our view, there is no guarantee that a 25-basis point hike in May will be the last rate hike. In other words, the banking system will continue to suffer from a decline in deposits and a painful inverted yield curve. The banking crisis of March will only add to the pressures and credit crunch that began months ago. 

Still, the banking system appears to be stabilizing from the March panic and loans from the Fed’s new Bank Term Funding Program fell modestly from the April 5, 2023 high of $79 billion to $73.8 billion on April 19, 2023. This is a ray of sunshine. But it is worth pointing out that now that the banks are no longer in crisis, the Fed’s policy of quantitative tightening has been reinstated. As seen on page 8, the Fed’s balance sheet contracted by $140 billion in the 4 weeks ended April 19, 2023. In short, the stimulus put into the banking system in March was temporary and is slowly reversing. This means that equities no longer have the wind at their back from this temporary liquidity boost. And this fading liquidity is beginning to show up in some technical indicators.   

Employment and Recession

A simple way to predict a recession is to monitor the year-over-year growth, or contraction, in jobs. See page 3. This indicator is simple, but useful, because the main characteristic of a recession is a decline in jobs. In the post-Covid recovery period job growth has been positive as people went back to work after the shutdown. And the year-over-year growth in both the employment and household surveys has been positive. The household survey has been the weaker of the two surveys recently and it decelerated to an “average” growth rate of 1.5% YOY in March. The interesting thing about job growth in the second half of this year is that comparisons will become more difficult when compared to 2022, and it is quite possible that job growth will stagnate of decline. We will be monitoring this in the coming months.  Meanwhile, consumer sentiment, which is normally a good indicator of a recession, has been extremely weak.

The Misery Index, which is the sum of inflation and unemployment, hit 12.7% in June 2022, a sign of household stress, but it dropped to 8.5% as inflation eased to 5% in March. However, March employment data included a small warning. The number of permanent job losers has been rising and was 26.6% of those unemployed in March. This is the highest percentage since December 2021. In sum, employment data could get weaker in the months ahead and job data will be the key to whether a recession appears in 2023 or 2024.

Technical Update

It has been a difficult equity market in which to maneuver and this can be seen by the year-to-date performances of the indices which are currently: S&P 500 up 6.1%, DJIA up 1.2%, the Nasdaq Composite up 12.7% and the Russell 2000 index down 0.9%. In other words, gains are concentrated in large-cap growth stocks this year, and we fear many of these large-cap favorites, with high PE multiples, may hit a major hurdle as interest rates continue to rise. See page 11.   The 25-day up/down volume oscillator is at positive 1.94 this week and neutral after recording one-day overbought readings of 3.0 or higher on April 18 and April 24. The inability of this oscillator to sustain either overbought reading reveals a weakness in underlying demand. We remain cautious.

Gail Dudack

Click to Download

Each earnings season is important since fundamentals are the underlying foundation for the equity market, and this is especially true for market rallies. And each earnings season has the potential of being a market-moving event, particularly if it is surprisingly good or bad. But in 2023, with the specter of a recession on the horizon, this earnings season seems even more important. To date, results have been mixed even though expectations have been dampened and earnings revisions have been heavily skewed to the downside prior to announcements.

Nevertheless, first quarter results may only be the tip of the iceberg in 2023. The mini-crisis in the banking sector which took place in March is widely expected to result in a credit crunch in coming quarters, and the impact of this will not be felt prior to the second quarter earnings season which will be reported in July and August. Therefore, investors will be forced to wait and see whether corporations are able to maneuver through the current minefield of inflation, rising interest rates, narrowing margins, and a hostile credit environment. Markets do not like uncertainty.

Our outlook is unchanged

Our outlook is unchanged. In our view, the risk of recession in 2023 is high since we believe the Fed’s policy of increasing interest rates will continue until inflation in the service sector and in wage growth has been broken. In other words, interest rates could go higher for longer. The banking crisis will increase the pressure on the economy, but we do not believe it will be enough to alter the Fed’s policy, at least, or until a recession is clearly in place. The consensus view of one more 25 basis point rate hike in May and the Fed is “done” could also be unwound if the rise in energy prices continues.

If energy prices continue to rise, the improvement seen in March inflation data will be a temporary phenomenon. And since earnings growth is apt to be modest or nonexistent this year, we believe the market will remain in a broad trading range in 2023. The best strategy for a rangebound market is to have core holdings of recession-resistant stocks, or companies with the most predictable earnings streams and dividend returns. However, a trading range market often includes a consistent rotation of sector leadership, and therefore shorter-term trading opportunities. Typically, value drives the rotation of leadership in a sideways market, and buying stocks which are depressed and holding them until the sector rallies is a tactical strategy for some investors. But this requires a nimble trading mentality and the discipline of selling once the stocks have been “discovered.”

Inflation Remains Sticky

March inflation data revealed a clear deceleration in pricing pressure, but it also showed a stubborn level of inflation in core prices. Headline CPI fell from 6% to 5% in March, but core CPI bucked the trend and rose from 5.5% to 5.6%. PPI for finished goods dropped from 6.4% to 3.2%, while core PPI eased only modestly from 6.8% to 6.5%. This discrepancy between headline and core inflation data is explained by crude oil’s 24.5% YOY decline in the same period. Meanwhile, import and export prices were both negative on a year-over-year basis for the second month in a row. In short, there has been good progress seen on the inflation front due to lower energy prices, yet core inflation remains high. See page 3.

Market pundits are focused on the decline in headline inflation in March, but the Fed Chairman Jerome Powell has been clear about his concern about wage inflation, particularly in the service-sector. This wage inflation will make the Fed’s job more difficult. As an example, the charts on page 4 from the Federal Reserve of Atlanta on the median year-over-year change in hourly wages show wage growth was 6.5% YOY in March. This was close to the highest growth rate seen since the survey began in 1983. The most recent cyclical peak was 7.4% YOY in June 2022. Wage inflation is nearly impossible to reverse without broad-based job losses – and job losses are the classic definition of a recession.

Total retail and food services sales fell for the second consecutive month in March but rose 2.9% YOY. Excluding motor vehicles & parts, sales rose 3.6% YOY. Gas station sales were the major drag on March sales, falling 14.2% YOY. As in the CPI, the falling price of crude oil and gasoline had a significant impact on March data. But as seen in the gasoline futures chart on page 9, this decline may be temporary. The only bright spots in the March report were nonstore retailer sales which were up 12.3% and food services and drinking places where sales jumped 13% YOY. See page 5.

Housing data was slightly better in March but remains in a longer-term slump. New residential building permits were 1.413 million (seasonally adjusted annualized rate) in March, down 25% YOY. Single-family permits rose 4.1% month-over-month but fell 29.7% YOY. Housing starts were 1.42 million, down 17% YOY. Single-family starts rose 2.7% month-over-month but fell 27.7% YOY. The March declines were concentrated in multi-family construction; however, both permits and starts in all categories were up from levels seen a few months ago. Homebuilder confidence inched up 1 point to 45 in April and though the index remains below the 50-benchmark denoting poor building conditions, there appears to be a bottoming process in confidence after the lows recorded in December 2022. See page 6.

Banking Crisis Aborted?

The Fed’s tightening policy and the historic 450 basis point increase in the fed funds rate in eleven months was destined to be disruptive to consumers and to the banking industry. The decline in commercial bank deposits totaled $967 billion at the end of March, and $473 billion of this exited the banking system in March alone. This drain on deposits was clearly at the crux of the banking crisis. However, this trend appears to be slowing a bit in April which should help stabilize the banks.

Bank loans through the Federal Reserve’s new Bank Term Funding Program fell from the April 5, 2023 high of $79 billion to $71.8 billion on April 12, 2023. This program was created to liquify the banking system and the fact that loans are being paid back suggests the liquidity crisis is abating. This is good news for the banks. However, it is unclear if higher interest rates and a weak commercial real estate sector is not going to be the next hurdle for banks in the months ahead. See page 7.

Technical Comments

The rally in the WTI crude future is not getting much attention but it does have implications for inflation later in the year. A downtrend line at $80 in the WTI is at risk of being broken, which would be bullish for oil prices. Gasoline prices have already had a positive break in a 9-month downtrend line. Gold is tentatively breaking out of a major consolidation with resistance at $2000. And lastly, the dollar is falling, which also has inflationary implications for the coming months. See page 9. The 25-day up/down volume oscillator is at positive 3.34 this week, to date recording one day with an overbought reading of 3.0 or higher. This overbought reading follows a 12-day oversold reading that ended March 23. In short, a flip-flop action between overbought and oversold readings has emerged since February and it defines the current market condition as being neither bullish, nor bearish, but in a long-term sideways trading range. More importantly, the longer the current overbought reading persists, the more likely it will be signaling an intermediate-term top. See page 11.

Gail Dudack

Click to Download

April has a good track record in terms of equity performance. Since 1931, April ranks second with an average gain of 1.6% in the S&P 500 index, bettered only by November with an average gain of 1.7%. In the Dow Jones Industrial Average, April ranks at the top of the performance list with an average gain of 1.9%, followed by November with an average gain of 1.7%. In both indices, December ranks third in terms of positive price performance. September ranks last for both indices, registering an average loss of 0.7% in the S&P 500 and a loss of 0.8% in the Dow Jones Industrial Average. In short, April has positive seasonality.

FOMC Update

Supporting the prospect of gains this April is the current expansion in the Fed’s balance sheet. However, this expansion was not due to normal quantitative easing but by the emergency measures put in place to calm the banking system after the bank run at Silicon Valley Bank. This liquidity spurt by the Fed was done through primary loans and the new Bank Term Funding Program and is expected to be short-lived. The good news in terms of the overall stability of the banking system is that these loans and credit lines have declined from the $390 billion dollar increase seen in the four weeks of March $287 billion as of April 5. So, while the recent increase in the Fed’s balance sheet could continue to boost stock prices in the very near term, it is already dissipating and should soon cease to be a positive factor for equities. See page 3.

In the longer term, we fear the banking system will continue to face problems in several areas due to the Federal Reserve’s tightening policies. Over the past year, deposits have been and will continue to drift away from the banking system and into higher-yielding securities like those found in Treasury bills, money market funds and mutual funds. This will decrease the banking system’s ability to make loans. And when one looks out into the future, it is likely that banks will encounter a second problem. A rise in corporate failures is a fairly normal event a year or two after a sharp rise in interest rates and this means banks may face a rise in defaults over the next twelve months. This phenomenon will decrease the desire of banks to make loans. In short, the banking system is getting squeezed in several directions which means a credit crunch is on the horizon. See page 4.

This credit crunch is the underpinning of an emerging consensus view that the Fed is apt to raise rates at the May 2, 2023 FOMC meeting by 25 basis points, but this rate hike will mark the end of the Fed’s tightening cycle. We are not convinced this will be accurate. There are a number of economic releases prior to the Fed’s May meeting, such as this week’s March inflation data as well as last month’s retail sales. A preview of auto sales for the month of March showed a steady deceleration from February’s pace. See page 6. Unless all these data releases show a notable decline in inflation coupled with a steady decline in household spending, we believe the Fed will continue to focus on getting to its 2% inflation target. The employment statistics for March, which showed a gain of 236,000 new jobs and a small decline in the unemployment rate to 3.5%, were clearly not going to convince the Fed to stop raising interest rates.

First Quarter Earnings Season

Although April has a good record of producing gains in the equity market, this year could be different. The first quarter’s earnings season will set the tone for earnings for the full year and to date, the quarter has been challenging.

The S&P Dow Jones and Refinitiv IBES earnings estimates for 2022 have stabilized at $196.95 and $218.09, respectively. (One reason for this 11% discrepancy is that S&P adjusts all estimates for GAAP accounting. IBES simply aggregates individual analyst estimates.)

Earnings estimates for 2023 are $217.78 and $219.83, and fell $0.60 and $0.62, respectively, this week. EPS growth rates for 2023 are now 10.6% and 0.8%, respectively, due to the discrepancy in 2022 estimates. However, we expect both of these consensus estimates will decline in the coming months. Our 2022 estimate is adjusted to match the S&P but our 2023 estimate of $180 is currently well below consensus since we have been anticipating an economic slowdown, a decline in top line revenues for many companies and a continuation of the margin pressure seen in 2022. Our estimate implies an 8.6% decline in earnings this year. Note that for the first quarter, now being reported, IBES is estimating a 5.2% decline in earnings for the S&P 500. This falls to a 6.7% decline if the energy sector is excluded. But keep in mind that most economists are now forecasting a credit crunch later in the year which means many businesses will face rising financing costs. In short, the first quarter’s earnings season could prove to be the best of the year. See pages 7 and 15.

Signs of a Slowdown

Last week we wrote that the ISM manufacturing index fell from 47.7 in February to 46.3 in March and that this was the fifth consecutive month below 50 for the manufacturing sector. All 9 components of the ISM manufacturing index were below 50 and order backlogs had a substantial decline from 45.1 to 43.9.

This week the March ISM non-manufacturing main survey was reported, and it showed a decline from 55.1 to 51.2. This is just slightly above the benchmark of 50 that divides expansion from contraction. All components of the survey fell with the exception of inventories and three components (order backlog, exports, and imports) fell below the 50 benchmark. In the service survey, exports experienced the biggest decline, dropping from a healthy 61.7 to a contractionary level of 43.7. See page 5. To sum up, an economic slowdown appears to be expanding to the service sector.

Technical Review

The long-standing inversion of the yield curve, the weakness seen in both ISM surveys, the sluggishness seen in recent auto sales, and the potential of corporate defaults after a year of rapidly rising interest rates, all point to the likelihood of a recession in coming months. Nevertheless, the technical condition of the market has improved! Still, the charts getting too little attention are on page 8. The rally in WTI crude futures has implications for inflation later in the year and at present, a downtrend line at $80 is being broken. Gasoline prices have already broken a 9-month downtrend line, which is positive for prices. Gold is close to breaking out of a major consolidation if and when it moves decisively above $2000. And lastly, the dollar is falling. The positive changes in these four charts all point to higher inflation this year, and therefore, more rate hikes ahead.   Meanwhile, our 25-day up/down volume oscillator remains in neutral, but the four popular equity indices have broken through downtrend lines that began at the 2021 highs. As a result, these chart patterns are currently favorable. Nonetheless, the Russell 2000 remains the best index to represent our view on the market. We are not chasing the current rally because we expect the market will remain in a relatively-flat and wide trading range. This range is best represented by the Russell 2000 which is trading between support at 1650 and resistance at 2000. See pages 9 and 10.

Gail Dudack

Click to Download

Geopolitical News

Although it was a relatively quiet week, there was a flurry of news items of some consequence. Finland, a country that borders Russia, officially joined NATO on April 4, drawing a threat from Moscow of “countermeasures.” Days earlier, in what could be a connected event, a Wall Street Journal reporter, Evan Gershkovich, was arrested and accused of espionage by Russia’s Federal Security Bureau.

The CEO of JP Morgan Chase & Co. (JPM – $128.42), Jamie Dimon, wrote in an annual letter to shareholders that “the current banking crisis is ongoing, and its impact will last for years.” In Dimon’s 43-page document, he also stated that he feels the odds of a recession have increased. At the company’s annual meeting in Zurich, the Chairman of Credit Suisse Group AG (CSGN – $0.81), Axel Lehmann, apologized to shareholders for taking the company to the brink of bankruptcy which required a government-sponsored rescue by UBS Group AG (UBS – $21.00).

Virgin Orbit Holdings Inc. (VORB – $0.15), founded by billionaire Richard Branson, filed for bankruptcy on April 4 after struggling to secure long-term funding after a failed launch.

NASA named the first woman and the first African American as part of the four-member team chosen to fly on the first crewed voyage around the moon in more than 50 years. Last, but far from least, Manhattan District Attorney Alvin Bragg led a team of prosecutors that charged former president Donald Trump for falsifying business records in order to conceal a violation of election laws during his successful 2016 campaign. It was a controversial legal move, but one that would make Donald Trump the first sitting or former US president to face criminal charges.

Economic News

On the economic front, this week’s surprising cuts to the OPEC+ group’s output targets, plus an extension of Russia’s output cuts from June to the end of the year, sparked a rally in crude oil futures (CLc1 – $80.71). Analysts indicated that oil prices could reach $100 a barrel later this year, given the existing tightness in the market. If so, it would complicate the Fed’s fight against inflation which is already compromised by the turmoil in the banking industry. The run-up in oil prices added fuel to a rally in gold (GCc1 – $2022.20) where the technical chart looks poised to break out of a three-year trading range. The top of the range for the gold future is currently at $2030. See page 8.

Job openings in February fell by 632,000 to 9.9 million, their lowest level in nearly two years. This survey was taken prior to the recent financial crisis, which means the next report may show a further decline. If so, it could be a positive for the Fed, and a sign that tight labor market conditions may finally be easing. The March job report from the Bureau of Labor Statistics will be released on Friday and it should also show a slowdown. If not, it may disappoint investors.  

The ISM manufacturing index fell from 47.7 in January to 46.3 in February, recording its fifth consecutive month below 50, i.e., the breakeven level. All components of the manufacturing survey were below 50 and order backlogs fell from 45.1 to 43.9. It was a report that signaled a deceleration in an already weak manufacturing sector. The ISM non-manufacturing survey will be reported later this week and it has been the strongest and steadiest segment of the economy over the last decade. The service sector typically represents over 43% of domestic GDP and it is on the Fed’s radar since it also represents the area of inflation where prices are yet to show a deceleration. See page 3.

The Conference Board’s consumer confidence index for March rose 0.8 points to 104.2, offsetting some of January’s hefty decline of 2.6 points. Conversely, the University of Michigan’s sentiment index fell from 67 to 62, offsetting some of the gains seen in January. The University of Michigan survey indicated that expectations dropped from 64.7 to 59.2 in the early days of March. In both surveys, consumer sentiment regarding present conditions fell during the month. This could deteriorate further if credit conditions continue to tighten, and energy prices rise. See page 4.  

Federal Reserve News

As we noted last week, the default of three regional banks resulted in a reversal in the Fed’s quantitative tightening policy. To settle the nervousness in the banking system the central bank is providing liquidity to the banking system in the form of primary loans and the newly established Bank Term Funding Program. Loans and credit lines on the Fed’s balance sheet increased from the $350 billion reported last week to more than $390 billion dollars this week. It has all been done since March 8 as an emergency measure to calm the global banking system and we believe this added liquidity could be a boost to stock prices in the near term. In fact, the positive correlation between an increase in the Fed’s balance sheet and equity gains is stronger than the negative impact on equities from rising interest rates. This makes us optimistic about the near-term outlook, but it comes with a caveat. This new quantitative easing is only temporary and could last for a period of weeks not months. See page 5.

In the intermediate term we expect the Fed to get back into tightening mode. Even after last week’s Fed rate hike of 25 basis points and the deceleration in February’s CPI to 6% YOY, the real funds rate narrowed to negative 100 basis points. But note, this spread is still negative. Historically, a Fed tightening cycle has ended with a fed funds rate averaging a positive 400 basis points. Statistically, this implies that if inflation were to fall to 3% this year (unlikely), the fed funds rate could rise to 7% by year end! This 7% fed funds rate may not appear in the current cycle, but overall, it points out that rates could go higher than any economist is currently expecting in 2023. See page 6.

Technical News

Last week the S&P 500, Dow Jones Industrial Average, and the Nasdaq Composite index, all rebounded from support created by the convergence of the 50, 100, and 200-day moving averages. This creates a positive technical chart pattern for the near term. However, the Russell 2000 index remains the best guide for investors in coming months. In our view, the market is and will continue to be in a wide trading range and this is most clearly seen in the Russell 2000 between support at 1650 and resistance at 2000. See page 9. The 25-day up/down volume oscillator is at negative 0.15 this week and in neutral territory after being in the oversold zone for 12 consecutive trading days in March. This oversold reading followed an eleven-day overbought reading that ended February 8. The February overbought reading represented a shift from a bearish to a positive trend, or at least from bearish to neutral. But this recent return to oversold territory clearly defines the current market as being neither bullish, nor bearish, but in a long-term sideways trading range. Trading ranges tend to include many short-term shifts in leadership. Note that the OPEC+ production cut appears to have shifted leadership from technology back to energy and staples.

Gail Dudack

Click to Download