A Head-Fake?
The S&P 500 broke its seven-week losing streak last week with a solid multi-day rally of more than 6%. In recent years, we've become accustomed to market corrections followed by rallies to new highs. Last week's rally could be the beginning of stabilization in equity markets, but it could also be a head fake. There are no rules, but market corrections of greater than 10% are often resolved by a capitulation day; when 90% of stocks close lower, and the volatility index peaks above 36. It will seem like all hope is lost on that day and that nothing good will ever happen again. We haven't had a day like that yet. Analysts have suggested that markets could retest the 3800 level or lower before stabilizing later in the year. Market corrections can also end with the resolution of the issues that caused markets to correct. Before we can move to new highs, I expect we will need to see progress toward a solution to the war in Ukraine, evidence that supply chains are normalizing, and a statement from the Federal Reserve that inflation is improving, and and indication that their policy may be less restrictive going forward.
Hot Economy, Inflation, and Recession
It may seem counterintuitive because we want economic activity and growth, but the economy is running too hot, causing inflation. The Federal Reserve is shifting to a more restrictive monetary policy to combat inflation and slow the economy. Before markets can move higher, we need to see evidence that the Feds policy is working and the economy is coming into balance. When the Fed has tightened monetary policy in most past cycles, the economy has slowed, stalled, and contracted into a recession, making a recession probable but not imminent. I am not expecting a recession like we saw in 2001 or 2008. There is a tendency to prepare ourselves mentally to fight the last recession. It's important to know that recessions aren't bad; they are part of the economic cycle and correct excesses and dislocations in the economy. The Dot Com bubble bursting in 2001 was caused by excessive speculation in technology companies that had little revenue or earnings. The technology sector is now one of the more profitable areas of our economy. The Great Financial Crisis resulted from speculation in the housing market, questionable mortgage investment vehicles, and an overextended consumer. Since then, regulations have strengthened the financial system; there is more need for housing than supply, and consumer and corporate balance sheets are relatively good. It is unlikely that the next recession, whenever it comes, will look like previous recessions.
The Labor Market and Inflation
Because the unemployment rate is unusually low, employees have more bargaining power than they have had in a long time. Higher wages are an expense to the employer that gets passed on to the consumer through higher prices. Unlike supply-related inflation, which can be moderated by increasing supply, wage inflation is sticky. Once employees' wages are set higher, it is difficult for prices to fall as those higher wages would need to be cut. We need the gap between job openings and the number of unemployed people to shrink to slow inflation. The unemployment rate rising to 5% would reduce inflationary pressures, but that is unlikely in the near term.
Economic Reports
Monday – The Energy Department's Retail Gas Price Report showed the national average for a gallon of gasoline was $4.69, up from $4.59 the week before and 50% higher than one year ago. With China scheduled to begin some reopening in early June, increased air travel, and the summer driving season, I expect gas prices to rise until they reach some level of demand destruction.
Tuesday – The Census Bureau reported Sales of New Single-Family Homes were down 16.64% in April, the fourth consecutive month of slower sales, as rising home prices and rising interest rates are slowing demand. Real estate in some markets is beginning to come into a balance between the number of buyers and sellers.
At this point, a slowdown in new home sales is a good thing and part of why markets rallied last week. The housing market has been too hot, and rising home prices have contributed to inflation.
Wednesday – The Commerce Department reported a month-over-month rise in New orders for Durable Goods of 0.44%, suggesting moderate economic growth.
Thursday – The Labor Department released the weekly number of Initial Claims for Unemployment Insurance - 210K vs. 218K the previous week. We've seen some rise in claims from historically low levels but not enough to indicate a change in how tight the labor market is.
Freddie Mac's Primary Mortgage Market Survey® - The average 30 Year Fixed Mortgage Rate is 5.25%, compared to 5.30% last week and 2.94% a year ago.
Friday - The Bureau of Economic Analysis released the Core PCE report (Personal Consumption Expenditures). This is the Federal Reserve's preferred measure of inflation and is the inflation rate with food and energy stripped out. They remove food and energy because those tend to be more volatile over shorter periods and can distort inflation data. Year over year, this measure of inflation was 4.91%, compared to 5.20% last month and 5.30% the month before.
Lower inflation data was a catalyst for the market moving higher Friday. If inflation falls, the Fed will have less work to slow the economy.
Next Week
Tuesday - We'll get the Case-Shiller Home Price Index which will inform our view on inflation.
Wednesday – The Institute for Supply Management will release their Purchasing Managers Index, giving us insight into the manufacturing sector.
The Federal Reserve Bank of New York will update its 12-month recession probability report. Last month's recession probability was 5.49%, well below the longer-term average.
Thursday – We'll get ADP Nonfarm Payrolls, Weekly unemployment claims, and the Bureau of Labor Statistics quarterly productivity report. All will be closely watched.
Friday – The Bureau of Labor Statistics monthly jobs report. I would prefer to see a weaker report, suggesting the economy may be slowing on its own. Though some are calling for the Fed to be more aggressive, I would be happy for them to move slowly and not break anything.
There are some minor signs of improvement in supply chains and inflation, but it is too early to know how meaningful. I believe the Fed will remain on its current course and raise interest rates by 0.5% at their June and July meetings. I think markets will continue to be volatile, but we could see some moderation and higher levels later this year. I do not believe we will see a recession in 2022, but we should not be surprised by a mild recession in 2023. This is not based on any current economic data but rather on the Federal Reserve's poor record at navigating rising rates.
