Market and Economic Update

I'm sure you've heard the news that the US economy is heading for a mild recession. This is the most expected recession ever. Signs of trouble started showing up over a year ago, and the signs still say we're heading for a recession.

The Federal Reserve Bank of New York says the recession probability in the next twelve months is 68.22%, the highest since 1982.

NY Fed Recession Probability Chart

A recession is when the economy shrinks; many define it as six months of negative GDP growth.

According to the Bureau of Economic Analysis, the first quarter's GDP was 1.1%, and the Federal Reserve Bank of Atlanta GDPNow estimates the second quarter's GDP will be 2.7%.

1st Quarter GDP Chart

2nd Quarter Federal Reserve Bank of Atlanta GDPNow Chart

Ahead of a recession, consumer confidence drops, and people spend less and save more. That's bad news for businesses that rely on consumer demand.

The University of Michigan, Consumer Sentiment Survey, shows consumer sentiment is falling.

Consumer Sentiment Survey Chart

Ahead of a recession, banks often raise lending standards and hold more cash. The Federal Reserve Bank of New York released the first quarter's Senior Loan Officer Opinion Survey on Bank Lending Practices. Survey respondents reported tighter standards and weaker demand for commercial and industrial loans. Survey respondents also reported tighter standards for both mortgage and consumer loans and weaker demand for mortgage loans, and consumer loan demand was mixed.

The SLOOS Report

The Fed is raising interest rates to fight inflation. Inflation is coming down but not as quickly as many had hoped. The Federal Reserve may have to keep raising rates higher than many expect to bring inflation down to its 2% target.

Inflation Rate vs. Fed Funds Rate Chart

How will this elusive recession begin? As Ernest Hemingway once said, "Two ways. Gradually and then suddenly." This quote is often used to describe how someone goes bankrupt. But it can also be used to describe how economies go into recession. The onset of a recession can be slow and then suddenly become more severe. I think we're experiencing a period of gradual economic weakening that may begin to accelerate.

Interest rate traders are currently pricing in rate cuts beginning in September, with six cuts over the next twelve months. If the Fed is cutting rates that quickly, I would expect it to be in response to a significant financial event or rapid slowing of the economy. I hope these expectations are wrong.

Fed Funds September 2023

Fed Funds May 2024

What are some things you can do to make it through a recession? There's no one-size-fits-all answer, but here are some general tips.

• Save more and spend less.
• Build an emergency fund that can cover at least six months of expenses in case you lose your income or face unexpected expenses.
• Pay down your debt. High-interest debt can eat up your cash flow and make it harder to cope with financial shocks. Try to pay off your credit cards and other loans as soon as possible.
• Consider diversifying your income. This could mean getting a part-time job or starting a side hustle.
• Review your budget and make cuts where possible. This may mean eating out less, canceling unnecessary subscriptions, or finding ways to save on your energy bill.
• Stay positive. A recession can be stressful and scary, but it's not the end of the world. Remember that recessions are temporary and usually followed by periods of growth and recovery.

Market and Economic Update

This week, market volatility continued as concerns about regional bank stability, Fed interest rate policy, and the possibility of a recession weighed on investors’ minds with the S&P 500 closing down 0.71% for the week. Let’s look at some of the latest economic data and see what it suggests about where the economy and markets may be headed.

For the most part, the S&P 500 has been range-bound between 3800 and 4200 for the past year. Up or down days shouldn’t cause much excitement or worry right now. A catalyst is needed to break out of this range.

Chart - Trading-Range

Monday:

The Federal Reserve Bank of New York updated its recession probability estimate to 57.77% - the highest it’s been in 40 years!

Chart - NY Fed Probability of Recession

The Institute for Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) rose to 47.1 last month, remaining below 50 and indicating a contraction. Meanwhile, the Manufacturing Prices Paid Index increased to 53.2, showing rising prices paid despite slowing manufacturing.

Chart - ISM PMI

Tuesday:

The Job Openings and Labor Turnover Survey (JOLTS) report shows a decline of 3.85% in non-farm job openings from last month, with 9.59M openings. The gap between job openings and unemployed persons is narrowing.

Chart - Unemployed Persons vs. JOLTS

Wednesday:

ADP private payrolls surged by 296K in April, beating expectations of 133K! This is further evidence that the labor market remains strong. The most significant gains were in leisure and hospitality, followed by education, health services, and construction. The financial and manufacturing sectors lost jobs in April.

Chart - ADP Private Payroll Report

As expected, the Federal Reserve raised the federal funds rate by 0.25% to 5% - 5.25%. This marks the 10th rate increase and the fastest pace in 40 years. Equity markets fluctuated during the Fed Chairman’s press conference and closed lower. Despite speculation that this is the end of the rate cycle, the Fed left the door open for future hikes and no plans for rate cuts this year. This week’s interest rate hike brings the Fed Funds rate to the same level as just before the Great Financial Crisis. While conditions are different, it’s interesting to note that this is the level where instabilities in some financial institutions began to be exposed.

Chart - Fed Funds Now vs. Great Financial Crisis

Thursday:

Weekly initial claims for unemployment insurance were 242K bringing the 4-week average to 239,250.

Chart - Weekly Jobless Claims

Friday:

The U.S. Bureau of Labor Statistics reported that April non-farm payroll employment rose by 253K, and the unemployment rate decreased to 3.4% which ties the record going back to 1969, while labor force participation remained steady at 62.6%. Average hourly earnings also increased by 0.2%. Low unemployment and rising wages potentially contribute to higher inflation and may prevent the Federal Reserve from easing monetary policy as quickly as some expect. The upcoming Consumer Price Index (CPI) report will provide further insight into the impact of the tight labor market on inflation. The Fed may act in response to significant disruptions within the banking system.

Chart - Monthly Unemployment Rate

With much of the earnings season behind us, it’s clear that while earnings have decreased year over year, they have still exceeded expectations. Next week, investors will shift their focus to inflation data while continuing to monitor the stability of regional banks.

Market and Economic Update

Switzerland has been known for its high-end watches and high-end banking, contributing to its reputation for quality, reliability, and security. Last Sunday, one of Switzerland's largest banks, Credit Suisse, was forced by the Swiss banking regulators to be taken over by Swiss bank UBS. It is believed that had the banks not merged, Credit Suisse would have failed. This follows several U.S. regional bank failures and fears that more will come. 

It is reported that billionaire investor and owner of the Carolina Panthers, David Tepper lost $17B in contingent convertible bonds as the Swiss government wiped out Credit Suisse stock owners and bondholders.

Monday – The average national retail gas price is $3.53, down 18.46% year over year. Falling gasoline prices and demand can indicate a slowing economy unless the decline is due to increasing supply which has not occurred.

• Portfolio Change – Underweight the Energy Sector.

Tuesday – In February, U.S. existing home sales increased by 14.5% to a seasonally adjusted annual rate of 4.58 million; however, they are down 22.64% compared to the previous year. This data is not as indicative of the economy's direction as usual. Most homeowners with mortgages have interest rates below 4%, and if they were to sell their current homes and obtain a mortgage for a new property, they would face higher interest rates. This factor discourages homeowners from selling, lowering the inventory of available existing homes on the market. Consequently, home builders may benefit, as a more significant percentage of home sales will likely consist of newly constructed properties.

• Portfolio Change – Allocation to the Homebuilders sub-sector.

Wednesday – The Federal Reserve's Federal Open Market Committee (FOMC) increased its rate by 0.25%, as anticipated, and maintained its 2023 rate outlook at 5.1%, implying another rate hike is expected. The written statement noted, "some additional policy firming may be appropriate," while removing the phrase, "ongoing increases in the target range will be appropriate." During the press conference, when asked about a potential rate cut in 2023, Chairman Powell responded, "rate cuts are not in our base case." Nonetheless, the bond market remains unconvinced. The Fed Funds Futures market is factoring in four quarter-point rate cuts in 2023 and an additional four in 2024. If the Fed reduces rates as aggressively as the bond market suggests, it could indicate a recession in the latter half of 2023.

• Portfolio Change – Reduced fixed income duration with an allocation to T-Bills. 

Thursday - Initial claims for unemployment insurance dropped by 1,000 from the previous week, reaching 191,000, which further supports the notion that the labor market continues to be tight. The Federal Reserve perceives a tight labor market as contributing to inflation since employees can request higher wages. These increased wages are then passed on to consumers through higher prices for goods and services.

Friday - St. Louis Federal Reserve President James Bullard increased his terminal Fed Funds rate target to 5.625%. He believes that banking system stresses will diminish in the coming weeks and months, and the robust economy may cause the Fed to need to raise interest rates further.

There is much uncertainty regarding the future path of markets and the economy. I will continue to monitor the market and economic data and adjust portfolio models accordingly.

Economic and Market Update

The S&P 500 bounced off its 200-day Simple Moving Average, ending the week up 1.9%, fueled by positive economic data indicating continued economic growth, although at a slower pace. Federal Reserve Bank of Atlanta President Raphael Bostic's recent comments to reporters also contributed to the market's upward trend. Bostic supports a cautious approach to monetary policy, stating that "slow and steady" would be the most appropriate course of action. Bostic's comments follow other Fed Presidents who suggested that a return to 0.50% rate increases could be appropriate if future inflation data is hotter than expected.

Below are some highlights from this week's economic data.

Monday:

US Durable Goods orders showed a 4.5% decline in orders for manufactured goods, but if we exclude transportation, durable goods orders grew by 0.69%. Passenger airplanes are big ticket items illustrating how much Boeing contributes to US manufacturing.

Tuesday:

Case-Shiller Composite 20-City Composite Home Price Index showed that year over year, home prices grew by 4.67% compared to 18.51% a year ago. The long-term average is 5.32%.

Wednesday:

Institute for Supply Management (ISM) Manufacturing Purchasing Managers Index was 47.7 compared to 47.4 a month ago, showing an overall contraction in the manufacturing sector for the fourth consecutive month. A number above 50 indicates growth, and below 50 indicates contraction.

Thursday:

Initial Claims for Unemployment Insurance were 190K lower than the 192K from the week before. Though lay-off announcements are increasing, it would seem those losing their jobs are quickly finding new jobs. Next Friday, we'll get a new Jobs Report from the Bureau of Labor Statistics (BLS). Last month showed a surprising monthly gain of 517K jobs and an unemployment rate of 3.4%. This was lower than expected and considerably lower than the longer-term average unemployment rate of 5.9%. The Federal Reserve views the tight labor market as inflationary. Another big jobs number would suggest that there is little slack in the job market and the Fed has much more work to do.

Friday:

The Institute for Supply Management (ISM) Services Purchasing Managers Index dipped to 55.1 from 55.2 the month before, showing expansion in the economy's service sector. A number above 50 indicates growth, and below 50 indicates contraction.

 

Summary:

There is a disagreement between the stock and bond markets regarding what comes next for the markets and economy. Stock market participants see evidence of a strong economy and job market and see equity prices going higher. The S&P 500 trades at 18 times 2023 expected earnings; the historical average is 16. Fourth-quarter earnings were better than feared, but many companies lowered their 2023 guidance suggesting that earnings estimates may come down, making the S&P 500 more expensive at current levels.

 

Interest rate traders are pricing in at least three more Fed rate hikes, and the Fed Funds rate staying above 5.25% through January 2024. The impact of earlier rate hikes are only now being felt in the economy. I struggle to believe we will see significant economic expansion while the Federal Reserve is raising interest rates to slow the economy.

The Federal Reserve Bank of New York increased the odds of a recession in the next 12 months to 57.13% from 47.31% last month.

 

The spread between the yield on the ten and two-year Treasury bonds, a reliable recession indicator, is more inverted than it's been in forty years.

Portfolio models remain defensively positioned. I am not anticipating a deep or pronged recession but rather the Fed winning the battle against inflation by contracting the economy. The S&P 500 is 15% below its all-time high and 13% above last October's lows, and I expect the S&P 500 to remain in this range. If the data changes, we'll adjust.

Economic and Market Update

This week, the S&P 500 fell 3% in response to data that showed the economy is resilient, but inflation remains stubbornly high. Although a strong economy is usually celebrated, this combination of factors will likely prompt the Federal Reserve to raise interest rates higher than previously anticipated. 

Tuesday - Monthly Existing Home Sales report from the National Association of Realtors, showing existing home sales have declined for twelve consecutive months.

Take Away - Most existing homeowners who have mortgages have interest rates under 4%. To sell their existing home and buy another would require them to buy a home that may cost more than their current home and finance it at a higher rate.

Tuesday – The weekly gasoline report from the Energy Information Administration report showed prices ticked down slightly this week but above the longer-term average.

Take Away – Growing economies require more energy. When the US economy reopened after the pandemic, we saw a spike in gas prices as demand grew faster than supply. A sudden spike or drop in gasoline prices could indicate changes in economic activity.

Thursday – According to Freddie Mac, the 30-year mortgage rates increased to 6.5% this week after falling earlier in the year.

Take Away – The Fed is trying to reduce inflation by slowing demand. Housing is a significant contributor to inflation, and the Fed is raising the cost of money to slow the demand for housing. I expect mortgage rates to follow as the Fed Funds rate rises.

Thursday – Weekly Initial Claims for Unemployment Insurance were 192K, lower than the previous week.

Take Away – There have been lay-off announcements, but they have not translated into claims for unemployment insurance. This could be due to generous severance packages or those being laid off from one company are quickly finding new employment. The Fed is trying to reduce inflation by slowing demand, including labor demand. Data that suggests that inflation remains high and the labor market tight will lead to the Fed further tightening monetary policy.

Friday - New Home Sales were up 7.2% in January month over month but still down 19.4% year over year.

Take Away – In the years leading up to 2007, homebuilders overbuilt. During the Great Financial Crisis, many homebuilders were left with homes they couldn't sell. Since the Great Financial Crisis, new home construction has lagged demand as homebuilders have been reluctant, fearing a repeat of earlier mistakes.

Friday – One of the Fed's preferred measures of inflation is PCE (Personal Consumption Expenditures). Core PCE excludes food and energy, not that food and energy aren't important; it's that food and energy are more volatile, and excluding them gives a clearer picture. The January report showed that inflation moved higher month over month.

Take Away – Reviewing statements made during the press conference following the last Fed meeting; I don't think higher inflation is what Chairman Powell expected. If the data we get between now and the next Fed meeting in March shows inflation continues to increase, we could see the Fed become more aggressive in its approach.

 

I believe we are in or on the cusp of a recession. An inversion of the yield curve between the yield on the ten-year Treasury Bond and the two-year Treasury Bond has often preceded recessions, and this part of the bond yield curve is the most inverted since 1981.

Interest rate traders have been increasing expectations for how high the Fed Funds rate will go. Currently, traders are pricing a 0.25% rate increase at the following three Fed meetings and remaining above 5.25% for the remainder of the year.

Market and Economic Update

This week's Market and Economic Update reviews several key indicators, including the Consumer Price Index (CPI), Retail Sales, Producer Price Index (PPI), Employment, and the economic health of the Consumer.

 

Recession Warning

I’ve warned that some of the economic indicators suggest a recession may be coming. Here I review some of the data I’m watching. 

Market and Econonmic Update

 The Market Rally

Equity markets have begun the year on an uptrend, driven by various factors, including lower inflation data and growing expectations that the Federal Reserve may end its interest rate hikes soon. Some speculate that the Fed may even lower rates later in the year. The S&P 500 finished the week at 4070, surpassing key technical indicators such as the 50-day, 100-day, and 200-day simple moving averages and breaking a long-standing trendline. This is considered to be a bullish signal, indicating that the market could continue to rise in the near term. It's worth noting that the S&P 500 recently reached this level on November 30th and September 12th, indicating that there may also be resistance at this price point.

S&P 500 Fair Value

One method to determine a fair value for the S&P 500 is to use a multiple of earnings estimate. This involves taking earnings estimates for the companies in the index and applying a multiple, such as a price-to-earnings ratio (P/E ratio), that reflects the price investors are willing to pay for expected earnings. This method can give an idea of where the index should be trading based on the anticipated earnings of its component companies.

The Rule of 20 is a method for arriving at a fair P/E multiple, which is used to estimate the intrinsic value of a stock or index. The Rule of 20 states that the fair P/E ratio is equal to 20 minus the inflation rate. The idea is that when inflation is high, investors will pay less for future earnings, and when inflation is low, investors will pay more for future earnings. This Rule is based on the assumption that a P/E ratio of 20 is fair when inflation is zero and that the fair P/E ratio should be adjusted based on the current inflation rate.

Earnings estimates for 2023 have been revised downward over the past year, with initial projections starting at $252. The current 2023 S&P 500 earnings estimate, according to S&P Dow Jones Indices, is $223. The P/E ratio, calculated using today's closing level of the S&P 500, is 18. 4070 would be fair value for the S&P 500 if the inflation rate fell to 2% and the current earnings estimates for 2023 are not revised downward any further.

Let's wait until next week

I want to be completely transparent. Our portfolio models remain defensively positioned and have underperformed their benchmarks in January. We are in earnings season, when companies announce their earnings for the previous quarter and give guidance for the following year. About a fifth of the S&P 500 have reported their earnings so far, and they have been okay but not impressive. Next week we will hear from some of the largest companies in the S&P 500 and the Technology sector, which has been the main driving force behind the recent market rally. Wednesday, the Federal Reserve will conclude its two-day meeting with a rate decision and a press conference, and on Friday, the monthly jobs report will be released. The market rally seems premature ahead of so many unknowns.

Outside the U.S.

The ongoing war in Ukraine continues to be a significant geopolitical risk. On February 5th, Europe will impose additional restrictions on Russian petroleum distillates, which could lead to increased price pressures on diesel and gasoline. While China's reopening is expected to be positive for the global economy, the increased economic activity will also lead to a rise in energy demand, further adding to the price pressure on oil. As a result, I anticipate that U.S. gasoline prices may rise in the coming weeks and months, contributing to inflation and inflation expectations.

Recession Risks

The 10-Year to 3-Month Treasury Yield Spread, a reliable recession indicator, remains inverted by -1.22%. The consumer remains resilient though we are beginning to see a slide in consumer spending. As long as the unemployment rate remains below the Feds' projected 4.5%, I would expect any recession to be mild unless you're one of the 4.5%. The Fed Funds Futures market implies the Fed will cut interest rates later this year, which would also suggest anticipation of a weakening economy and rising unemployment.

Market and Economic Update

The Rhino Report - November 17, 202

The econonmic data can tell us a story if we'll read it objectively. Let's review some of the current econonmic data and see what conclusions we can draw.