Last month’s inversion in the 10-Yr./3-Mo. Treasury spread further tilts an already lopsided scale in favor of a U.S. recession in 2023. That spread has been considered the gold standard from an economic forecasting perspective, and is the basis for the New York Fed’s Recession Probability estimate (which, by the way, should break above its critical 35% threshold when it’s published later this month.)
If there’s a polar opposite to “Goldilocks,” this must be it. Not too hot and not too cold? What about both? Job growth and inflation are hot enough to force the Fed to follow through on its hawkish promises. But the leading indicators continue to warn us of oncoming cold. The odds that the porridge settles at the right temperature, without an intervening recession, look longer by the day.
NIPA’s “all-economy” profit margin declined a bit in Q4—which typically peaks before SPX profits—and that falloff coincided with the economy officially reaching full employment, based on the CBO’s Nominal GDP Output Gap. When the Output Gap has flipped positive (like in Q4), corporate profit margins usually come under immediate pressure.
In a simple test of 15 yield-curve variants, we found that the 2s10s spread ranks second to last, based on its correlation with one-year-forward real-GDP growth since 1978. The three best measures employed the 3-month bill as the “short” rate. The spread between the 5-year note and 3-month bill showed the strongest correlation with subsequent economic growth.
The economic expansion officially entered its 22nd month in February. In dog years, that translates to an age of 13—the same age the recovery might have reached this July if not for the COVID disruption. The late-cycle characteristics displayed by a recovery that’s statistically so young dissuade us from issuing a high-conviction forecast for 2022.
If NBER is correct that a new economic expansion began in mid-2020, then this cycle is unfolding in “dog years.” After limiting between-meal snacks earlier this year, champion-breeder Jay Powell has informed his pack of canines that their portions will also be reduced as of later this month.
In the latest Green Book, we noted that Producer Price Inflation does not usually become a challenge for the stock market until its annual rate breaks above 4.0%. The day that comment was published, the year-over-year gain in the March PPI for Finished Goods spiked to 6.0%, thanks mostly to the well-celebrated COVID-19 anniversary-effect.
March’s mad dash for cash didn’t stop with rates/credit/FX markets. Among equities, there was also a strong preference for cash liquidity. The market rewarded companies that had strong cash positions and punished those without—which explains why traditionally defensive styles actually underperformed.
We can’t count the number of times in the last week we’ve heard analysts worry about “what the Fed might know that we don’t.” In the words of John McEnroe, “You cannot be serious!”
The consensus among market pundits is that a U.S. recession will be averted and, as a consequence, domestic stocks remain the best game in town.
A way to gain perspective on the present is by trying to view it from the future. Ask yourself, “What are the signs of impending decline, now ignored by investors, that will one day be memorialized by the same investors as the most obvious in retrospect?”
It’s now been more than 19 months since global stocks peaked on January 26th, 2018. Those lucky enough to have been invested solely in the S&P 500 and to have held on for the volatile ride have a 3.7% gain to show for it. Nice going.
Over a 12-month horizon, we now believe a U.S. recession is very likely, but aren’t confident enough to make the call when the forecast window is cut in half. Second-half stock returns could be decent if the business-cycle peak is still a year away. Then again, there’s peril in waiting for “too much” confirmation of recession.
The U.S. economy and blue chips have shrugged off the risk of the worst trade war since 1930’s Smoot-Hawley Act, while comparatively few stocks on either the NASDAQ or the NYSE have broken out to 52-week highs. There’s also the troubling talk of the Fed having tamed “the cycle.” Should investors bet on a potentially wild (but narrower) final melt-up over the next 6-12 months? We don’t like the odds.
We thought Jerome Powell’s “Christmas Capitulation” would be tough to beat, but he accomplished that two days ago with what could be called his “Spring Surrender.” That, in turn, has rekindled hopes of a stock market melt-up along the lines of 1998-99, which, as old-timers will remember, followed a late-cycle correction that was nearly identical to the one seen last year.
While the celebration over Jerome Powell’s “Christmas Capitulation” lingered throughout February, we’re still awaiting signs the capitulation consisted of anything more than words.
Throughout the spring and summer, the market could alternatively be characterized as “divergent” or “disjointed”—but until very recently it could not be considered “distributive.” Now, Mid and Small Caps have hit a short-term air pocket and breadth figures were exceptionally poor at September’s scattered highs in the DJIA and S&P 500.
Yes, bulls and bears now hold their respective positions for the same reason—i.e., the U.S. economy is exceptionally strong. The stock market is accommodating this rare bipartisanship with sufficient reason to support either position.