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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Bank Turmoil

Equity investors turned cautious ahead of this week’s FOMC meeting and we are not surprised. For one thing, regional banks continue to be under pressure despite the fact that over the weekend, in a relatively smooth transition, the FDIC stepped in, seized control of First Republic Bank, and sold its assets to JPMorgan Chase & Co. (JPM – $138.92). Yet, this buyout is no guarantee that the banking industry has stabilized. In fact, the stocks of many regional banks continue to suffer from intense selling pressure. There are multiple reasons for this.

Even though the 2023 banking crisis has been managed relatively well so far, it is not a “small event.” The three US banks that collapsed this year (First Republic, Silicon Valley Bank, and Signature Bank of New York) had more combined assets under management than all 25 federally insured lenders that failed in 2008. According to the New York Times, this year’s three failed banks held a massive $532 billion in total assets versus the $526 billion in combined assets of the 25 banks with FDIC insurance that failed in 2008.

Meanwhile, deposits continue to leave the banking industry. In the twelve months ending in late April, commercial bank deposits fell by $960 billion, with $464.0 billion exiting the banking system since the early March banking crisis. And unfortunately, it is questionable if the banking system has stabilized since loans in the Fed’s new Bank Term Funding Program rose to a new high of $81.3 billion on April 26, 2023. This is a sign of illiquidity in the system. At the same time, the Fed’s balance sheet contracted $171 billion in the 5 weeks ended April 26, 2023. See page 3.

In short, the Fed has resumed its monetary tightening at the same time that money is leaving the banking system for higher yielding assets. Confirming this trend is data from Refinitiv Lipper which indicates that investors purchased a net $42.68 billion worth of money market funds in the week ending April 26, which makes the cumulative money market fund inflows for the year $427.4 billion.

And the commercial banking industry faces the risk of rising bad debts later in the year. The Wall Street Journal recently reported that a 22-story glass and stone tower at 350 California Street in San Francisco, worth about $300 billion in 2019, is now for sale and expected to see bids come in around $60 billion! More surprisingly, life-sciences buildings, typically less vulnerable to the remote-work movement since lab work requires specialized equipment and mechanical systems that can’t be replicated at home, are also coming under pressure. A deluge of new supply in industry hubs such as San Diego, South San Francisco, and the Boston-Cambridge region, is generating a rise in life-sciences vacancies, according to commercial real estate services firm CBRE Group. In short, we expect banking will continue to be under duress from a combination of dwindling deposits, an inverted yield curve, and potential defaults. And note, short-term interest rates have not yet reached their peak.

This week’s FOMC is expected to result in an additional 25-basis point increase in the fed funds rate to a range of 5.00% to 5.25%. However, important information will be found in whether the vote was unanimous for this rate hike or not, and whether or not the Fed’s comments suggest a pause in rates will follow the May increase. Equity investors expect the Fed to be more accommodating in the second half of the year, which means anything slightly hawkish in Chairman Jerome Powell’s comments would be a negative surprise for the market. We expect Chairman Powell will try to be as vague as possible about future monetary policy and will resort to being “data dependent.” And economic data is quite a mix at the moment. Keep in mind that the Fed’s meeting will be followed by expected rate increases by the European Central Bank on Thursday and the Bank of England next week, which means credit conditions are contracting globally. This means equity markets no longer have the wind at their back.

Economic Data Jumble

The March JOLTS report showed 9.6 million job openings, down 2.5 million over the last year and now at the lowest level since April 2021. In another sign that the labor market is cooling, the quits rate edged lower to 2.5%, the lowest point since February 2021.

GDP grew at 1.1% in the first quarter of the year, disappointing consensus expectations, but it is worth noting that personal consumption rose a fairly healthy 3.4%. It was the drag from inventories which contracted 2.3% that lowered GDP. See page 4.

However, the drag from inventories may not be over as seen in recent ISM data. The ISM manufacturing index rose from 46.3 to 47.1 in April but for the sixth consecutive month it remained below the 50 level that shows a contraction in activity. Nine of the 11 components rose in April, and surprisingly two of these, employment and prices paid rose above 50. This is not a good sign for the Fed since it is looking for weakness in both inflation and employment. The major drag on the April ISM index was inventories, which means second quarter GDP is starting on a weak note. See page 5. The ISM services index will be reported later this week.

Personal income rose 6% YOY in March and wages rose a more robust 7% YOY – a sign that wage inflation continues. But after being negative for 19 of the 21 months between April 2021 and December 2022, real personal disposable income increased 4% YOY in March for the third consecutive month this year. This shift is an indication of a gain in purchasing power and it is good news for the consumer. As a side note, March disposable income benefited from a 7.3% YOY decline in tax payments. The savings rate rose from 4.8% to 5.1% in the month and now exceeds $1 trillion. See page 6.

Personal consumption expenditures continue to increase on a year-over-year basis, but the trend is decelerating. Spending on services is highest with an 8% YOY increase, while nondurable spending is growing at a modest 2.6% pace. What surprised us in the data was that personal outlays rose 6.9% YOY in March whereas personal consumption expenditures rose only 6% YOY. Digging through the data we found that interest payments rose a stunning 52% YOY in March, which helps explain the differential. In other words, wages are rising, inflation is moderating, and real personal disposable income is improving. But at the same time, a steady increase in interest rates and interest expenses are eating up a good portion of these gains. In sum, higher interest rates are clearly hurting household consumption. See page 7.

Technical Update

The combination of falling crude oil and gasoline prices, coupled with the relatively positive performance of gold this week, implies that investors have become increasingly worried about a recession. The dollar has been stable in recent sessions despite its weakness since early March, but this is not surprising given that interest rates are expected to rise this week. See page 9.

This year’s equity gains have been concentrated in the most depressed stocks of 2022, the high PE growth stocks. And with interest rates headed higher this week it is not surprising that the April rally hit a roadblock. The Russell 2000 remains the best guide for what we believe is a trading range market as it trades between support at 1650 and resistance at 2000. See page 10. We would point out that the 10-day average of daily new highs is 87 and new lows are 87. This combination is neutral since neither new highs nor new lows are above 100; but the combination is also turning negative as the number of daily new highs declines. See page 12. Although we focused on the risk in the banking industry this week, the looming debt ceiling debate may be the biggest problem for investors in coming weeks. Friday’s employment report is another potential market-moving event. Plus, this is the biggest week for first quarter earnings reports. In the long run, it is valuation that will strengthen or weaken equity prices. We remain cautious.

Gail Dudack

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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

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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

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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

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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

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As expected, the Federal Reserve did raise the fed funds rate by 25 basis points to a range of 4.75% to 5.00% last week. However, in reality, the Fed’s overall tightening policy is being offset by its need to increase liquidity in the banking system which has been under intense pressure since regulators took control of Silicon Valley Bank (SVB Financial Group – SIVBQ – $0.40) on March 10.

Short-term Rally?

As the central bank moved quickly to add reserves to the banking system in the form of primary loans and through the new Bank Term Funding Program (BTFP), the Fed’s balance sheet expanded by nearly $350 billion dollars in recent weeks. See page 3. This quick response appears to have assuaged depositors who were concerned about the stability of regional banks. And while the crisis seems becalmed for the moment, the Fed’s action may also provide a few better days for investors. History shows that there has been a strong relationship between the Fed increasing its balance sheet (adding liquidity to the banking system) and rising stock prices. In sum, equity prices could rise in the near term.

However, we worry this will only deliver short-term comfort. The banking crisis could also result in tighter credit conditions for consumers and businesses and many forecasters are now suggesting that the Fed will cut rates in the second half of the year. This is a possibility, but only if it becomes clear that the economy is spiraling into a recession (which means corporate earnings will collapse!). Even so, the Fed may not cut rates quickly since history shows that high inflation has only been corrected by a recession. Unfortunately, the relationship between inflationary cycles and recessions is a strong one. Whenever inflation has risen more than two-standard deviations above the norm, or above 6.5%, the economy has suffered, not one, but a series of recessions. See page 4.

Higher for Longer

It is obvious that headline inflation has begun to decelerate but core inflation remains stubbornly high. Core CPI was only down 0.1% in February to 5.5% and this reflects the fact that pricing pressure is now concentrated in the service sector. In the CPI, service inflation was unchanged in February at 7.6% YOY. Service sector inflation less rent was 6.9% and pet services inflation rose 10.9% YOY. These are worrisome figures. The PCE deflator for February will be released Friday and it will be closely analyzed for any signs of service sector relief.

We believe the Fed governors when they state that they do not foresee an interest rate cut later this year. And the reasons are many. The Federal Reserve has never been this far behind the curve in terms of fighting inflation. Historically, a Fed tightening cycle began at the first sign of inflation and it ended with a real fed funds rate reaching at least 400 basis points. This latter point is quite different from the consensus view. What it means is that if inflation should fall to 3% this year (which we deem unlikely) the fed funds rate could rise to 7% by year end! See page 5. We doubt that interest rates will get this high, but we do expect the Fed to keep interest rates higher for longer than the consensus currently believes.

Using Technical Guidance

Most of the broad market indices are trading at prices that are close to levels representing the convergence of the 50, 100, and 200-day moving averages. See page 8. This convergence of moving averages should function as good support for the recent sell-off, however, as support, it is also pivotal. If the indices break below current levels it would likely trigger more selling. In other words, the next several weeks should be an interesting time for technical analysts; however, as we previously noted, the Fed’s recent quantitative easing should provide some near-term support for equities.

Meanwhile, our 25-day up/down volume oscillator is at negative 1.91 this week, which is a neutral reading after being in oversold territory for 12 consecutive trading days. This oversold reading follows an eleven-day overbought reading that ended February 8, and which represented a shift from a bearish to a positive trend, or at least from a bearish to a neutral trend. This new oversold reading clearly defines the market’s trend as being neither bullish, nor bearish, but in a long-term sideways trading range. See page 9. Keep in mind that in this 25-day oscillator, bull markets rarely reach oversold territory and bear market rallies rarely reach overbought readings. The current market is oscillating between overbought and oversold and therefore neutral. Other technical indicators such as the 10-day average of daily new highs and lows are more negative. We use 100 per day as the definition of a trend and new highs are currently averaging a weak 35 per day and new lows are averaging 189. See page 11.

The best example of the trading range we are expecting for the intermediate term is seen in the Russell 2000 index. See page 10. The Russell 2000 is heavily weighted in regional bank stocks, which some might say should make it a less predictive indicator; nevertheless, a bull market has never materialized without the participation of the financial sector. It is core to the economy. Therefore, we are closely monitoring a well-defined trading range in the Russell 2000 between support at 1650 and resistance at 2000. The RUT’s current price of 1753 is 6% from support and 14% from resistance, implying a slightly positive short-term risk/reward ratio.

S&P GICS Changes

ETF’s have become popular trading vehicles recently and we expect this to continue particularly since the trading range market we are expecting should see a continuous rotation of sector leadership. Therefore, we have reprinted a summary of GICS classification changes that took place in March. We expect these changes will impact not only the price performance of some SPDR ETF’s but it will also change the earnings in several categories. See page 7 for details.

The largest change will be seen within Information Technology, where eight constituents will move to the Financials sector and three constituents will move into the Industrials sector. From a market cap perspective, Visa Inc. (V – $220.33) and Mastercard Inc. (MC – $354.33) will be the largest changes and they will now rank as the 3^rd and 4^th largest constituents in the Financial sector and move into a newly created sub-industry titled ‘Transaction & Payment Processing Services’. The other sector impacted is Consumer Discretionary, which will see Target Corp. (TGT – $159.77), Dollar General Corp. (DG – $208.13), and Dollar Tree Inc. (DLTR – $141.66) all move into the Consumer Staples sector and the ‘Consumer Staples Merchandise Retail’ sub-industry. Target Corp. now ranks as the 9^th largest constituent in the Consumer Staples sector. Financials will see the largest increase in earnings weight next quarter, rising from 17.6% to 19.7% (+2.1 ppt) due to Visa Inc. and Mastercard Inc., followed by Industrials (+0.3 ppt), which will be offset by the decline in Information Technology (-2.6 ppt). Consumer Staples will see its earnings weight rise moderately (+0.4 ppt) which will be offset by Consumer Discretionary (-0.3 ppt).

Gail Dudack

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In our opinion, the Federal Reserve will raise the fed funds rate by 25 basis points this week to a target range of 4 ¾% to 5%. And we say this even though we agree with those who say it makes no sense to raise rates during a time of global banking distress. However, the Federal Reserve has backed itself into a corner this week and any move it makes – raise, pause, or pivot — is apt to draw criticism. As a result, Chairman Powell is likely to take the easiest road and follow the consensus view of a 25-basis point increase.

Unfortunately, the Fed is boxed in between a number of bad choices and finds itself in a lose-lose situation. Still, it is a situation of its own making. First, for too long the Fed ignored an inflation problem exacerbated by its prolonged zero interest rate policy and then it rushed to fix its error by raising interest rates 425 basis points in 10 months. The sharp rise in interest rates coupled with the most inverted government yield curve since 1981 proved difficult to handle for some, particularly, for those with no experience with inflation or inverted yield curves. The disruption seen in the banking industry is no surprise to us; although we would have expected the liquidity problems to first appear outside the US and not inside.

It is possible that a 25-basis point increase will soothe the markets. A pause could suggest that the Fed sees too much instability in the banking system to raise rates. A 50-basis point increase could certainly add to the pressure already seen in global banking. Thus, 25-basis points may prove to be the best choice. But it is unclear whether the global banking system has truly stabilized. Clearly, the Fed and the Swiss government stepped in to calm the jitters caused by runs at three regional banks in the US and at Credit Suisse Group AG (CS – $0.97) in Switzerland. Consequently, the tightening policies that were in place are now in conflict and diluted by the emergency liquidity measures put into place to save the banks. Our longer-term concern is that banks will continue to face pressure this year from an inverted yield curve, a shaky commercial real estate market, and rising credit card debt. History suggests that sustainable rallies in equities are not likely without participation from the financial sector. In short, we remain cautious.

Monitoring the risk in the debt markets will be important in the days ahead, even for equity investors. One benchmark we have followed is the ICE BofA MOVE Index (.MOVE – $162.31) which is a measure of expected volatility in US Treasuries. Last week it surged close to $200, its highest level since the financial crisis of 2008. It has since retreated to $162.31 but remains elevated and is a cause for concern. See page 2.

According to History

By studying the relationship between inflation and the economy over the last 80 years, it becomes clear that whenever inflation, as measured by the CPI or PPI, has reached 9% or more, it has been followed by not one, but by a series of recessions. This was true in the post-World War II era as well as the double-digit inflation seen in the 1970 decade. It is possible that the two negative quarters of GDP seen in the first half of 2022 was the first, in what may become a series of economic slowdowns. See page 4.

And it is also important to note that there is a unique difference between past inflation cycles and the current environment. The Federal Reserve has never let inflation rise this far before raising rates. In past cycles, the Fed increased interest rates as soon as inflation began to climb and kept rates in line with inflation. The Fed is way behind the curve in today’s cycle which could make inflation more difficult to control. History also shows that in tightening cycles with very high inflation, monetary policy was interrupted by the onset of a recession. This forced the Fed to lower rates temporarily. Unfortunately, after a decline of a year or more, inflation reappeared, and the Fed’s tightening cycle resumed, lifting interest rates to even higher levels. This is the backdrop for a series of economic recessions. We believe Chairman Powell understands this and will try to avoid the historic pattern of stop-and-go tightening. But he is walking an economic tightrope and it will not be easy. See page 5.

Inflation Abating

Recent inflation data has been somewhat encouraging. In February, headline CPI fell from 6.4% to 6.0% YOY. Core CPI ratcheted down from 5.6% to 5.5%. Finished goods PPI improved the most falling from 8.7% to 6.4% YOY; while final demand PPI dropped from 5.7% to 4.6%. But the concern is service sector PPI which was unchanged at 5.5% YOY. All in all, these were well above the long-term average pace of 3.4%. See page 6.

The best inflation news was found in trade-related benchmarks. Import prices fell from 0.9% YOY to negative 1.1%. Imports less petroleum eased from 1.4% to 0.2% YOY and export prices dropped from 2.2% YOY to negative 0.8% YOY. But while inflation has moderated by most measures, the real fed funds rate remains 80 basis points below the PCE deflator (5.4%) and 150 basis points below the CPI. See page 7. This is the most compelling reason for the Fed to still raise interest rates by 25-basis points at this week’s meeting.

To add to this mix of data, there were some green shoots in housing data recently. In particular, the NAHB confidence index rose from 42 in January to 44 in February. Yet, despite these gains, all components are still below the 50-equilibrium level. At the same time, existing home sales increased from the 4.0-million-unit rate seen in January to 4.58 million in February. Again, despite this gain, sales were nearly 23% below the rate seen a year earlier. See page 8.

In February the median existing home price rose to $367,500 from $365,400 in January. This was a 0.7% YOY decline and the first year-over-year decline since September 2011. The price of a new home also declined in February and the 3-month average dropped to 3.5% YOY. But while year-over-year declines in home prices are good for future inflation data, total retail sales have a strong relationship to home prices. This suggests that retail sales could also be weak this year. See page 9.

Watch the Russell

We think the Russell 2000 index remains the best technical guide for market direction in the near and intermediate terms. Our forecast has been for a trading range marker and the Russell index is the best example since it continues to trade between support at 1650 and resistance near 2000. The current price of 1777 is just slightly below the midpoint of the range, which could be viewed as slightly positive, i.e., allowing for a brief short-term rally. See page 11. But we remain cautious and would continue to focus on recession and inflation proof stocks with solid earnings and dividend growth. Note: this week we have lowered our 2022 earnings forecast of $200 to $196.82 to match the S&P Dow Jones estimate. See pages 10 and 17.

Gail Dudack

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The famous soothsayer warning of “beware the Ides of March” to Julius Caesar in Shakespeare’s play of the same name, could be fitting advice for today. In Roman times, March 15 was a day of religious observances and a deadline for settling debts, but it will always be famous as the date of Julius Caesar’s assassination. Wall Street has adopted this phrase because equity performance in the first half of March often begins in a promising way but ends on a weak note. This year a mid-March alert is interesting because it comes at the intersection of February employment statistics, the consumer and producer inflation reports, three bank failures and an important FOMC meeting, among other things.

Bank Failures

However, it is the bank failures that have captured all of the media’s attention. It began with the cryptocurrency-focused Silvergate Bank (holding company Silvergate Capital Corporation SI – $2.21) which announced early in March that it would be forced to liquidate due to large losses in its loan portfolio. On March 10, Silicon Valley Bank (holding company SVB Financial Group SIVB – $106.04), which concentrated its business on technology startup companies and venture capitalists, was seized by regulators to abort a run on the bank. Both of these banks were California-based banks. Signature Bank (SBNY – $70.00*), a New York-based bank with sizeable business with cryptocurrency firms, was closed by regulators on March 12. None of these were small issues; in fact, the collapse of Silicon Valley Bank and Signature Bank marked the second- and third-largest bank failures in the history of the United States. However, all of these, and Silicon Valley Bank in particular, appear to be examples of poor risk management on many levels, and not similar to the 2008 banking crisis, in our view. Still, the risk of contagion still exists, and it could take weeks to understand all the fallout.

Nevertheless, we would like to point out that there were many important announcements taking place this week aside from Silicon Valley Bank. Credit Suisse Group AG (CS – $2.51) was forced to delay its annual report due to questions from the Securities and Exchange Commission. The report, eventually filed on March 14, confirmed there were financial control weaknesses in 2021 and 2022, and the company reported a loss of $8 billion for 2022. This was Credit Suisse’s largest loss since the 2008 financial crisis. Not surprisingly, customers continue to withdraw money from the bank. This is Switzerland’s second largest bank and one of nine global bulge bracket banks providing services in investment banking, private banking, and asset management.

Alaskan Oil

And in an unexpected turnaround, the Biden administration approved the ConocoPhillips (COP – $101.36) oil drilling project in Alaska’s North Slope on March 14. This $8 billion Willow project is expected to produce over 600 million barrels of petroleum over a 30-year period.

*March 10, 2023

The Rise of China

But the most important event of mid-March may have been that Chinese President Xi Jinping brokered a diplomatic truce between Saudi Arabia — a long-standing American ally — and Iran — a long-standing American antagonist. This deal will end seven years of estrangement between these two oil-producing countries, but more importantly, it signals a major increase in China’s influence in a region of the world where the US had been the main power broker. For Iran it eases the international isolation that the country has experienced for years and for Saudi Arabia, it creates more leverage in terms of negotiating with the Biden administration. In the longer run, this deal may prove to have a lasting impact on global politics or become a significant turning point. And it comes as Russia continues to bomb Ukraine and Russian fighter jets clip the propeller of an American spy drone flying over international air space in the Black Sea. The economic significance of all this is unknown at the moment, but we are watching the performance of the dollar. Dollar weakness could persist if the US is perceived to be weakening politically and economically. And a weak dollar makes imports more expensive, i.e., it is inflationary.   

The FOMC

Three bank failures will make next week’s FOMC meeting more interesting than anyone had anticipated. However, the announcement of the Federal Reserve’s lending program might give the Fed the flexibility it needs to raise rates 25 basis points next week. Under the Bank Term Funding Program (BTFP), the Fed will provide banks with one-year loans at the rate of a one-year overnight index swap (OIS) plus 10 basis points. Banks can use eligible government securities like Treasuries and agency mortgage-backed debt to guarantee the loans. And most importantly, the program values these at par rather than at mark-to-market. Selling Treasury bonds as rates were rising is what put pressure on Silicon Valley Bank. We do not expect the Fed to surprise the equity market, but to the extent that traders have already priced in a 25 basis points increase, the Fed is apt to take that opportunity and raise rates.

History shows that tightening cycles rarely end without the fed funds rate reaching at least 400 basis points above inflation. By these two standards, even if inflation falls to 3% YOY, which is optimistic, we should expect interest rates to move higher and stay high longer than expected. This is most likely to end in a recession. As we have often noted, whenever inflation reaches one standard deviation above the norm, or higher, a series of recessions have followed. One standard deviation above the norm is currently 6.5%. See page 6. In short, we believe investors should focus on defensive and recession-resistant stocks.

Technical Update

Our focus index is the Russell 2000 index this week due to its sizeable exposure to regional bank stocks. Currently, the index is rebounding from a very sharp decline; nonetheless, the overall pattern reveals the index is in a broad trading range. This is much in line with our long-term view. See page 9.

The 25-day up/down volume oscillator is negative 3.36 this week and has been in oversold territory for four consecutive trading days. This follows an eleven-day overbought reading that ended February 8. The February overbought reading was an indication of a shift from a bearish to a positive trend, or at least from bearish to neutral. However, this week’s return to oversold territory clearly defines the current market trend as neutral. See page 10. The 10-day average of daily new highs is 69 and new lows are 131 this week. This combination is now negative since new highs are less than 100 and new lows are above 100. The advance/decline line fell below the June low on September 22 and is currently 40,117 net advancing issues from its November 8, 2021 high. This collection of indicators has shifted from neutral to negative this week.

Gail Dudack

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Economic data has been a tale of two cities in recent months. And after reviewing the latest survey releases, it is clear one could build a case for or against an economic recession in the coming months. However, those arguing that current data is much too strong for a recession should remember that recessions are rarely visible at their onset and are notoriously acknowledged only in hindsight by the National Bureau of Economic Research (NBER).

In terms of data, February’s ISM non-manufacturing index fell 0.1 to 55.1 but remained well above the 49.2 reading in December when it was signaling a decline in economic activity. Five of the nine components deteriorated in February, but business activity declined from 60.4 to 56.3 and accounted for most of the decline. The manufacturing survey was below the 50 benchmark for the fourth consecutive month, yet the components of the index were mixed. The main manufacturing index rose to 47.7, up a notch from January’s 47.4 reading, which was the lowest reading since May 2020. Manufacturing production fell from 48.0 to 47.3 and prices paid rose 6.8 points to 51.3. See page 3.

In the non-manufacturing survey, new orders rebounded from January’s 60.4 to 62.6. In the manufacturing survey, new orders also rose strongly from 42.5 to 47.9, however, the index remained below the 50 benchmark which is a sign of declining economic activity. Employment indices were also mixed. In the non-manufacturing survey, employment rose from 50.0 to 54.0 representing an expansion, while in the manufacturing survey employment fell from 50.6 to 49.1, representing a contraction. In general, both surveys displayed an erratic slowdown in employment during the October to December period. See page 4.

Inflation

Given the dramatic response of the equity and fixed income markets to Fed Chairman Jerome Powell’s testimony to Congress this week, it seems appropriate to repeat some of our historic charts on inflation and interest rates to see what history can disclose. In our view, a good deal of today’s statistics suggests a recession is ahead and possibly as soon as the second half of this year.

Over the last 80 years, whenever inflation has reached a standard deviation above the norm or greater — for the CPI this equates to a level of 6.5% or more – not one, but a series of recessions has followed. One could say it will be different this time, but we think that would be a high-risk judgment. From our perspective, the two negative quarters which appeared in early 2020 were the first, in what may become a series, of recessions. See page 5.

More importantly, monetary tightening cycles have rarely ended before the fed funds rate was at least 400 basis points above inflation, i.e., reaching a real fed funds yield of 4%. In other words, if inflation falls to 4% this year, a history of fed funds rate cycles suggests the fed funds rate should reach 8%. Clearly, this possibility has not been discounted by the market. But even if the current cycle is different and the economy is more interest rate sensitive than in prior cycles, we should still expect interest rates to move higher than 6% and stay high longer than expected. Unfortunately, this scenario is apt to end in a recession. See page 5.

On a happier note, debt levels in the financial, corporate, and household sectors are not as extreme as those seen in 2007 or at other economic peaks. From this standpoint, any future recession should be relatively mild.

Yield Curves

As already noted, Federal Reserve Chairman Powell’s hawkish testimony to Congress was a wake-up call for those believing interest rates were at or near a peak. And by the end of the trading session, as shorter-term yields soared, the closely watched inversion between yields in the two-year and 10-year Treasuries reached negative 103.1 basis points. It was the largest gap between short- and longer-term yields since September 1981. As a reminder, in September 1981 the economy was in the early months of a recession that would last until November 1982, becoming what was at that time the worst economic decline since the Great Depression. What history shows, and what is obvious in the charts on page 6, is that an inverted yield curve has always been followed by a recession. However, the lag time can be long. Equally important, recessions are always accompanied by an equity decline.

Valuation

Despite the fact that inflation has declined from the June 2022 peak of 9.1% YOY to January’s 6.4% YOY pace, inflation remains historically high. February data will be released on March 14, and it will be closely followed. In our opinion, investors are underestimating the impact inflation has on equity valuation. A simple way of defining the negative relationship between inflation and PE multiples is expressed by what we call the rule of 23, formerly known as the rule of 21. Historically, if the sum of the S&P’s PE multiple and inflation exceeds 23, the market is extremely overvalued. This typically results in lower stock prices and lower PE multiples. After this week’s sell-off, we estimate the trailing PE of the S&P 500 to be 20.2 and the forward PE to be 21.8. A more optimistic earnings estimate of $220 for this year could bring the 12-month forward PE to 18X, nevertheless, this combination of PE multiples and an optimistic assumption of 4% for the CPI, still places equities at the very top of the fair value range. See page 7. 

On page 8 we show the inputs to the Rule of 23 to demonstrate that PE multiples are well above average despite the fact that inflation is also above average. Historically, double-digit inflation has resulted in single-digit PE multiples. And though the June inflation high of 9% did not reach double digits, it was high enough to put pressure on high PE stocks and in time this should result in PE multiples closer to the long-term average of 15.8 times. See page 8.

The relationship between the S&P price index and earnings is not perfect, but earnings cycles typically lead price cycles. This has been particularly true since 1990 and since 2008 the 5-year rate of change in earnings and the S&P price have been strongly correlated. At present both trends are decelerating, which explains why the next few quarterly earnings reports could be market-moving events. We do not see anything on the horizon that could trigger an acceleration in earnings growth, on the other hand, the persistent rise in interest rates could certainly be a headwind to earnings growth. Last, but far from least, higher inflation means higher interest rates, and at present, the yields on both Treasury bills and notes are close to or higher than the earnings yield on the S&P 500. This makes fixed income an attractive alternative to stocks for the first time since 2000. See page 9. In sum, we remain defensive and would emphasize stocks that are both inflation and recession resistant and/or have attractive dividend yields.

Gail Dudack

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