US Strategy Weekly: Inflation, Recession, and Earnings Math

At the May meeting of the Economics Club of New York, the New York Federal Reserve President John Williams said it is too early to say if the central bank is done raising interest rates. He added that “officials have not yet decided what lies ahead in terms of possible increases in short-term borrowing costs and if more action is needed policymakers won’t hold back.” This is not in line with the consensus which shows a 78% chance that the Fed is likely to pause rate increases at the June meeting. More importantly, fed futures now reflect a 45% chance that interest rates will actually be cut 25 basis points at the September meeting.

Keep in mind that while FOMC just raised the fed funds rate 25 basis points last week and the next FOMC meeting is only five weeks away on June 13-14. Nevertheless, we believe there is a good chance that the consensus could be disappointed, and the Fed could raise interest rates again. This explains why the CPI and PPI data reported this week will be so important. It could have a big impact on sentiment.

Inflation Math

Yet from a purely mathematical perspective, the peak rate of inflation of 9.1% was recorded in June of last year, and this means it could, or should, be easier for the year-over-year inflation rate to move steadily down as we approach mid-year. When we checked our database, we found that if the headline seasonally adjusted CPI data remained unchanged on a monthly basis for April, May, and for June, headline inflation would fall to 2.4%. This would be a very pleasant surprise for most economists. Either way, new inflation data will be crucial in the coming months.

But first, it will be important to see what headline and core inflation were in April and if there is any moderation in service sector pricing. Inflation data for May will be reported prior to the June FOMC meeting, which means the Fed governors will have several new data points on inflation before their next meeting.

The controversy surrounding the May FOMC meeting was whether the Federal Reserve should raise interest rates in the wake of a banking crisis. However, the crisis appears to be fading. Loans on the Fed’s balance sheet rose by $339 billion at the onset of the March banking crisis, but loans have been on the decline and by early May fell $36.4 billion from the March 22 peak of $354.2 billion. From a broader perspective, the Fed’s total balance sheet has been contracting, which means that quantitative tightening has been reinstated. This is good news since it lowers the risk of inflation in the broad economy, nevertheless, it does remove the positive bias that quantitative easing has for equities. See page 3.

Recession Math

April payrolls increased by 253,000 and the unemployment rate fell 0.1% to 3.39%. This decline in the unemployment rate now matches the low last seen in 1969, or 54 years ago! This robust growth in jobs and a historically low unemployment rate reflect a resilient job market and unfortunately for the Fed, a strong job market will only make its inflation goals more difficult to achieve. The bottom line is that it adds credence to the possibility of another rate hike in June.

Rising interest rates usually increase the risk of a future recession, however, there is another interesting math equation worth pointing out about recessions. The data series we have found to be the best lead indicator of a recession is a year-over-year decline in total employment. In fact, in the eleven recessions recorded since 1950, each was immediately preceded by a decline in total employment. Given that job growth has been robust, the US economy does not appear to be at risk of slipping into a recessionary state in the near future. However, this may also be one reason the Fed will continue to raise rates further than expected. The strong job market should give them a safety blanket, at least in the near term. See page 4.

On the other hand, small business owners are not optimistic about their future. The NFIB optimism index slipped to 89 in April. This was the 16^th consecutive month below the long-term average of 98 and it leaves the index at levels typically associated with a recession. Twenty-four percent of business owners indicated that labor quality was the top business problem. Inflation was in second place by one point at 23%. Plans for capex, employment, or to increase inventories have been declining for much of the last twelve months. Expectations for real sales, economic improvement, and better credit conditions also fell in April. See page 5.

Earnings Math

The economy may not be on the brink of a recession, but earnings are already experiencing their own recession. According to IBES, first quarter earnings for this year are currently $438.1 billion, down 0.7% YOY and down 0.4% month-over-month. This marks the second consecutive quarter of negative growth. Earnings declines are expected to continue into the next quarter when estimates suggest a 4.7% YOY decline. See page 7.

Using S&P Dow Jones earnings estimates on a 12-month trailing basis, earnings turned negative in April. When looking at reported earnings, the 12-month trailing earnings stream has been negative since October 2022, i.e., for the last two quarters. See page 6. In short, while the job market may not suggest a recession is in sight, earnings are already experiencing a recession. This is apt to continue since the consumer and small businesses have been crippled by high inflation and rising interest rates this year. All in all, this explains why the stock market has been stuck in a trading range for most of the last twelve months. See page 10.

Technical Roundup

The charts of the S&P 500, Dow Jones Industrial Average, and the Nasdaq Composite are all technically positive, but each faces a critical level of resistance near current levels. These levels are SPX 4,200; DJIA 34,500; and Nasdaq 12,500. The Russell 2000 remains our favorite guide for the market since it remains well within a defined range with support at 1,650 and resistance at the 2000 level. It is worth noting that the Russell 2000 has been underperforming the larger capitalization indices and this is a cause for concern. And even though the index is moving toward the bottom of its range, we remain cautious. Our main near-term concern centers on our lack of faith that the debt ceiling negotiations in Washington DC will be done in good faith and if we are right, it will have a negative impact on the dollar and the securities markets. Most other technical indicators are neutral and inconclusive. The 25-day up/down volume oscillator is at negative 0.62 this week. This is in neutral range, but only after being unsuccessful at sustaining an overbought reading. In sum, we remain cautious and continue to focus on recession-resistant stocks where both earnings and/or dividends are most predictable.

Gail Dudack

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