Market Update

The S&P 500 rose to 4,169.48 last week, a gain of 0.87%. The Nasdaq gained 1.28%. The S&P is up 8.59% year-to-date. The index traded sideways Monday. It fell 2.2% Tuesday and Wednesday, bottoming in the last few minutes of trading Wednesday. Thursday and Friday saw a strong rally from 4055 to 4170, a gain of 2.8%. The week was dominated by earnings news.

Banks are still in the news. First Republic looks as if it is going down. The stock has lost 98% of its value. The Federal Deposit Insurance Corporation (FDIC) has asked other banks for bids. Bloomberg is reporting that JP Morgan Chase and PNC Financial are preparing offers. Bank stocks may take another hit this week as investors worry about more trouble in the sector. There will likely be more shoes dropping. The basic problem hasn’t gone away and looks to get worse as the Fed meets this week. The Fed will raise the fed-funds rate by 0.25%, taking it to 5.0%-5.25%. The FedWatch tool shows an 83.9% probability of a quarter-point hike.

The problem is that many banks have large unrealized losses in their bond portfolios. The banks own Treasuries, which are credit risk-free. But Treasuries aren’t interest rate risk-free. Bond prices fall as rates rise. It doesn't matter what type of bond, that basic relationship holds. And the longer the term to maturity the more sensitive prices are to interest rate changes.

Banks gorged themselves on longer-dated Treasuries with excess deposits. Deposits are a short-term liability for banks. Depositors can get their money back at any time. Meanwhile, the banks bought Treasuries that won’t mature for years, even decades. The FDIC estimates bank unrealized losses totaling more than $620 billion. Another fed-funds rate hike will likely increase unrealized losses. It will also put more pressure on deposits as people shift savings to money market funds.

Higher for longer will only exacerbate the banking system’s asset-liability mismatch. The FedWatch tool is starting to price in the possibility of another hike in June. It is estimating a 26.8% chance of a June hike. It is estimating a 21.5% chance of yet another hike in July. That is more than the estimated chance of a rate cut.

The likely catalyst for the shifting expectations is the most recent inflation data. The Core PCE index rose 0.3% in March, the same as the prior month. The Core PCE year-over-year was 4.6% in March, down from 4.7% the prior month. The Core PCE is more than twice the Federal Reserve’s target of 2%. It is unlikely the Fed will stop hiking until inflation subsides. A still strong jobs market, including 50-year lows in unemployment, make a 2023 rate cut unlikely. It is more likely that the Fed continues to raise in 2023 than cut.

Banks will continue to struggle in a higher for longer interest rate environment. The rest of the stock market might join them. The year-to-date rally is narrow. We wrote last week about the narrowness of the rally. Less than a third of stocks in the S&P 500 have outperformed the index. It is the fewest since 1999, writes Desh Peramunetilleke, head of microstrategy at Jefferies. Five stocks have delivered 60% of the S&P 500 returns YTD. Investors appear to be diving back into the winners from the 2017 – 2021 bull market run. Apple, Microsoft, Nvidia, Meta, and Amazon aren't likely to drag the index higher on their own though. More stocks will need to join the rally if it is to continue. History tells us that narrow rallies don’t last.

Economic Indicators

The economy slowed in Q1. It rose 1.1% in Q1, down from 2.6% in Q4 2022. The Consumer Conference Board and the Federal Reserve are predicting a recession in 2023. The first quarter GDP number adds weight to their forecasts. Inflation remains high despite the slowing economy. The Core PCE rose by 0.3% in March. It rose by the same amount the prior month. The Core PCE year-over-year rose 4.6%, above market expectations of a 4.5% increase. The Sticky Price Consumer Price Index Less Food and Energy rose by 6.45% in March. Sticky Price CPI has stopped increasing but hasn’t yet started decreasing meaningfully.

The job market remains tight. Jobless claims fell to 230,000 from 245,000 the prior month. Continuing claims fell to 1.86 million in March from 1.87 million. The Employment Cost Index rose by 1.2% in Q1, faster than the 1.0% in Q4 2022. The Federal Reserve is concerned about wage inflation remaining elevated. It won’t hit its 2% target for inflation without a drop in wage inflation. Wages and salaries increased 1.2% from December 2022. Wages and salaries increased 5.0% for the 12-month period ending in March 2023.

It is unlikely the Federal Reserve will cut in 2023. It will only cut if there is a significant economic slowdown. The Fed will raise the funds rate to 5.0% - 5.25% Wednesday. It is probable it will raise rates in June as well. The stock and bond market still don’t appear to believe the Fed really means “higher for longer”. They should.

Long and Variable Lead Times

The economy is a complex thing. Many variables interacting with one another. Humans are part of the dynamic and humans learn. Humans change their behavior as they learn. Economic complexity and changing human behavior mean that no two business cycles are the same. Forecasting economic activity is difficult as a result.

The current business cycle is different because of Covid. The amount of fiscal and monetary stimulus was large. Aggregate supply was constrained as supply chains were disrupted. Generous fiscal support contributed to an increase in the demand for goods during the pandemic, according to the Fed. The supply curve shifted left (fell), and the demand curve shifted right (increased) causing inflation to surge. Too many people competing to buy too few goods will always cause a general increase in the price level.

The Federal Reserve responded with the most rapid rate hike cycle since the early 1980s. Interest rate hikes reduce demand. The demand curve shifts left (decreases) and prices fall. The demand curve shifts left because consumers can’t consume as much when the cost of money is rising. Consumers can’t consume as much because they can’t borrow as much.

Falling demand means falling prices. Falling prices means reduced profitability. Businesses must reduce output and cut costs when profitability declines. Labor is the biggest cost for most businesses. People lose their jobs and unemployment rises as businesses cut labor costs. Rising unemployment causes the demand curve to shift further left. The unemployed can't spend as much.

There are many moving parts interacting with one another in an economy. The complexity, the feedback loops, changing human behavior, all ensure that no two economic cycles will be the same. It also ensures that the economy’s response to monetary policy isn’t the same from business cycle to business cycle either. The Fed acknowledges that it may be 18 months to two years or more before tighter monetary policy materially impacts economic activity. It’s a big window. The Fed is acknowledging with that statement that monetary policy is a sledgehammer not a scalpel. Long and variable lead times make it difficult to forecast economic growth during an interest rate-tightening cycle. It also makes it difficult to know when enough is enough.

Although each cycle has differences, certain relationships will always exist. For instance, rising interest rates will always destroy demand. The cost of money is an input. Businesses will cancel projects when the cost of funding becomes prohibitive. Consumers will curtail spending as the cost of borrowing increases. Timing and magnitude are unknown though.

Different industries feel the impact at different times. The housing industry is the most interest rate sensitive. The auto industry is also interest rate sensitive. Both industries are leading indicators for the economy. The consumer discretionary sector is more sensitive to changing interest rates than the consumer staples sector. People need to eat. They don’t need to buy another pair of pants. While details differ from cycle to cycle, many of the basic relationships between macroeconomic variables remain the same. Rising interest rates will cause the demand curve to shift left (decrease).

A recession is coming. It is a question of when. Later this year is a reasonable base case. Interest rates are high and likely going higher. The economy is slowing down albeit more slowly than anticipated. Unemployment will rise as demand falls. Some industries will feel the pain more than others.

Regards,

Christopher R Norwood, CFA



Chief Market Strategist