How Long? How Bad?
As we have stated numerous times, we are faced with a menu of bad options. After 20+ years of ever-increasing, Fed-induced, financial largesse, inflation has turned the tables and we face the inevitable reversal of that largesse. There are no good options. The Fed will remain optimistic to the end, but the odds of pulling off a ‘softish’ landing are minute.
What we saw this week was the bond market flexing its muscle and sending a message to the Fed… ‘We are in charge now’. At this point, the Fed is losing the narrative and that makes the bad options worse.
The key indicator from this point forward is not the level of interest rates, it is economic growth and the data is deteriorating. It is not a disaster yet, but it is clearly trending down.
The questions then become, how long and how bad. There is no supply remedy for energy inflation; demand destruction is the only solution available. The Fed is stuck with a choice of a quicker, but potentially shorter, recession, or continuing to pretend they can thread the needle and risk a deeper, longer recession later on.
With the caveat that you can never really trust the words of the Fed (or any central bank) during a time of crisis, the comments from the Fed meeting on Wednesday would imply they are choosing the former, while still holding out hope that they can thread the needle. The Fed has laid out a plan of future interest rate hikes that take us well above the neutral rate (the neutral rate is a theoretical rate that does not encourage or discourage economic growth). The message is that they are in this inflation fight to win it. Our view continues to be that a recession is a necessity to win the inflation fight.
The Trajectory Matters
The post pandemic rebound is largely still intact, but the trend beginning to roll over. By far, the most positive feature is employment. Unemployment remains very low. The U.S. remains in a position with more available jobs than people to fill them. It’s very tough to have a recession while that remains true, which makes the employment data critically important to watch for signs of developing weakness, such as growth in the number of initial unemployment claims each week. As seen in the chart below, a 4-week moving average of Initial Claims remains at a very low level, however, initial unemployment claims are clearly beginning to rise. The trajectory matters. If initial claims continue to rise with some consistency, a recession alert will be sounding loud and clear.
This is the crux of the Fed’s problem. If new unemployment gathers steam, that would normally call for a policy easing, i.e., lower interest rates. The conundrum is that a policy easing would also serve to stoke the coals of inflation. They are damned if they do and damned if they don’t.
Other parts of the economy are still strong, but with cracks beginning to appear. With house prices up 20% in the last year and 30-year mortgage rates reaching 6% this week, housing affordability has sunk to lows last seen just before the subprime housing crisis hit. April housing starts had the largest one month drop since the start of the pandemic. The trajectory matters. This is especially meaningful as the housing market has long been a key driver of economic growth in the U.S.
Possibly the most telling is the University of Michigan Consumer Sentiment Survey, which recently hit a new low, just below the level seen in 1980, in the middle of the last inflation scare. The trajectory matters. It is also interesting to note that low points in consumer sentiment are highly correlated with recessions (gray shaded areas) and a new shaded area appears ready to be added.
Our conclusion remains that a recession is coming. The questions that remain are when it arrives, how long it will last, and how deep it will be. The Fed appears to be on a path to sooner, shorter and shallow, but that, as always, is subject to change.
What Can That Mean for the Stock Market?
In our discussions this week, we concluded that a recession could impact corporate profits to the tune of 10% to 15%. With 2022 earnings estimates for the S&P 500 still holding at about $225, we see downside to about $200 per share. Apply a 16 P/E multiple on those earnings and that brings us to a target of 3,200 for the S&P 500, with the caveat that market typically overshoots to the downside as well as the upside. Buckle up, it could be a long, difficult summer. But once growth estimates are revised, buying opportunities should appear.
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