Pivot Points
• April 12, 2023, was the six-month anniversary of the S&P 500’s 2022 closing low, off 25% from the January market high last year. Since that October low, the S&P 500 has recovered 14%.
• Signs of some stabilization in the banking industry following early quarterly earnings reports are helping soothe investor concerns in the financial sector. This change follows the Fed’s injection of approximately $400 billion back into the economy over a two-week period in March.
• A pullback in oil prices—and nine rate hikes—is helping dampen inflation concerns, as have continued declines in ISM readings in both manufacturing and service industries.
•Producer prices (PPI) and consumer prices (CPI) both fell in March, tangible evidence that inflation pressures are indeed easing.
Inflation risks fading in the rearview mirror
March CPI and PPI inflation reports both suggest that inflation pressures are on the decline. Consumer price inflation slid to 5% on a year-over-year basis, versus last month’s 6% measure. These readings show the slowest pace for price increases since 2021, when they first began their climb, and those increases are well off last June’s 9.1% peak. Core prices, however, excluding volatile food and energy items, increased 0.4% from February, following a 0.5% bump in the previous month. That pushed up March’s annual increase in core inflation from 5.5% to 5.6%.
Although the “sticky” nature of core inflation is still worrisome, there is evidence that the current level will continue to decline. Shelter costs are one of the largest components of core inflation, and March’s data showed that “rent or owners equivalent rent” rose 0.5%, the slowest monthly increase in almost a year. And at this stage of the rate tightening cycle, it is unlikely that this shelter cost trend is an outlier. The past nine rate hikes finally seem to be dampening consumer demand at levels sufficient to pressure (or reverse) post-pandemic price inflationary pressures.
This past month’s data from the Producer Price Index was even more surprising: The sharp drop to 2.8% annualized growth from the prior month’s 5.0% was the lowest rate since January 2021. The decline was primarily impacted by a drop in energy prices, off by 6.4% (the fourth decline over the past five months). Other notable PPI surprises were transportation and warehousing industries, off -1.3% (ninth consecutive decline) and wholesale and retail trade industry margins, off -0.9% (third consecutive decline). Bottom line, both CPI and PPI, coupled with the weakened price indicators such as the ISM data and regional Fed reports, are implying “disinflation,” the new watchword.
Whether this March report will encourage the Fed to pause further hikes in the upcoming May meeting is a “wait and see” game because the economy is still 3% away from the desired official inflation target of 2%. The Fed has said all along, however, that it wants to see progress on inflation. So far, the data from March through mid-April suggests a work in progress.
Manufacturing Recession
Reported data over these past four weeks have highlighted quite a few moving parts still impacting manufacturers here and abroad. First, the dollar index (DXY) is off about 10% from a September peak, for companies with overseas operations, which tends to bode well in terms of global market pricing and competitiveness. Renaissance Macro noted a 10% drop in the U.S. dollar increased real exports by 3% the following year. Unfortunately, the weaker dollar also means more expensive raw materials and finished goods imports, which, in turn, creates renewed inflationary concerns.
At the same time, there has been quite a bit of downward pressure on crude oil and natural gas, generally indicative of an economic slowdown. Recent OPEC production cuts announced to begin in May certainly have the potential of creating a floor in oil prices, but those cuts may not be enough to support certain segments of the oil industry. Fuel demand, for instance, has declined a bit this year, most noticeably for diesel fuel. Given current trends, including a slowdown in freight delivery, diesel demand is expected to fall around 2% this year, which would be the biggest drop in U.S. diesel demand in seven years (excluding the 2020 pandemic year). Looking at West Texas Intermediate (WTI) oil prices since June’s peak pricing last year, prices are off by 35%. Natural gas has likewise fallen by 77% since last August, while heating oil has fallen by 42% from last June.
On the manufacturing front, the March ISM (Institute of Supply Management) report indicated manufacturing activities had fallen for the fifth consecutive month to an index reading of 46.3, the lowest since May 2020. Although not yet worrisome, a fall to an index reading of 45 has presaged a recession 11 out of 12 times over the past 70 years. Meanwhile, the March ISM Services PMI also fell to an index reading of 51.2 (versus the prior month’s 54.5), the lowest level since 2010 (again excluding pandemic 2020).
On a positive note, however, the overall measure of industrial production in the U.S. managed to post an uptick in the March activity reading, also mirrored in April’s New York Fed Empire Manufacturing Index. The +10.8 reading was the first move into positive territory since last November and the highest since July 2022. Most impressive was the new orders reading, which leveled out to the April 2022 peak.
After the next two months, if the Fed hits the pause button on further rate hikes, April data might be a pivot point that reverses the declining ISM data and a launching point for continuous improvement in regional Fed district economic reports. If monetary policy tightening continues beyond the next meeting in early May, don’t be surprised if the positive April industrial production data becomes the outlier and downward pressure on the Manufacturing and Services ISM readings continue.
Consumer Resilience
Although fears of both inflationary pressures and an ensuing recession began to surface following the first interest rate hike 13 months ago, today’s consumer is still in relatively good shape. Consider that since the beginning of January 2020 and continuing through April 15, the S&P 500 is up 28%, and the NASDAQ composite is up 35%. Also, consider that the Case-Shiller National Home Price Index is up 38% over the same timeframe, while wages have risen 53%.
So far, the combined economic stimulus and support from mostly forgiven pandemic stimulus payments, the wealth impact of a still intact housing market, and job and stock markets continue to support consumer activities. Travel, measured by TSA screening, was up 8.1% as of February 15 versus four years ago, with 2.1 million passengers checking through airport security. And hotel occupancy was back on track, with bookings on pace with 2019.
The job market, one of the underlying support systems for consumer outlook and well-being, was again headline news in March. A year after the Federal Reserve began aggressively raising interest rates, the labor markets remain solid, with the unemployment rate still sitting at 3.5% and wage growth up 4.2% over last year. Job gains in a number of service businesses also continue to offset the headline layoffs in a number of higher-profile companies.
For those worried about inflation, data also notes an increase in weekly jobless claims and declining job openings—some evidence that job market growth is also on the cusp of flattening out. Although I wouldn’t expect a sudden increase in the unemployment rate, an uptick closer to 4% would lessen the Fed’s inflation concerns.
On the retail front, sales trends are now slowing. Although retail sales were up 2.9% on a year/year basis, when adjusted for inflation, they were down by -1.9%, the lowest growth rate since May 2020. Before COVID, the only other time retail sales fell below 1% (inflation-adjusted) was during the 2007-2008 financial crisis. The March sales report showed growth for only five of the 13 retail sectors. The five with March growth numbers included online shopping, healthcare-related industries, sporting goods stores, and bars and restaurants. The biggest laggard was gasoline station sales (-5.46%), mostly a function of lower oil prices.
The other reliable consumer-tracking metric is housing. There are a few longer-term positives benefitting the housing market, including a still declining housing inventory and improving homebuilder sentiment. But negatives exist, such as the drop in housing starts last month, with starts declining by -0.8%. When viewed over a 12-month average, the data represented the 10th consecutive monthly decline.
Time will tell if the decline in housing starts was more of a seasonal anomaly or a trend, as most of the decline in starts was attributable to weather issues. Backing out those water-logged areas in the Western states, housing starts were up 8.3%, representing the third monthly increase and the highest since June 2022. Also, good news was that single-family permits rose for the first time in 13 months as builders started to ramp back up despite 6%-plus mortgage rates.
In spite of concerns that housing markets remain under mortgage rate pressure, investors have been aggressively bidding up home building stocks back to 52-week highs. Although these housing-centric issues generally rally during periods of falling rates, 2023 has again been different, raising the question once more about whether investors are bidding up housing stocks because they are anticipating (or wishing) for a turnaround in mortgage rates and the housing industry. Once investors confirm a drop in interest rates, I would expect some continuing rebound from current price levels. The opposite is true, with market gains quickly unwinding in the face of higher rates and still further shrinking inventory.
Market floor or ceiling?
March was a volatile month for the capital markets. The Federal Reserve’s now 13-month hike cycle contributed to the banking system stress underlying the shuttering of three regional banks, a forced takeover of Credit Suisse, government intervention and the creation of a new special lending facility for distressed Treasury securities. And though volatility was extreme with specific equity groups, including financial securities, the broadly volatile index VIX was relatively quiet.
Today the VIX is trading fresh 52-week lows and obviously nowhere near overbought levels on the weekly timeframe. Its highest close in March was at a level of 26.52 before retreating to a near one-year low as of this writing.
Against the backdrop of the banking crisis last month, the Fed was quickly adding liquidity back into the system as investors hit panic buttons on a number of banking stocks, including the Regional Bank ETF, falling more than 27% in three trading sessions. Even so, March still closed on a rather strong upbeat, with the S&P 500 booking gains of 3.7%. In terms of quarterly performances, the S&P was up 7.5% (mirroring the fourth quarter of 2022), surprising given the banking volatility and sell-off in the last month of the quarter. What was not surprising, perhaps, was the financial sector’s performance for the month as the laggard at -9.6%. This return contrasted with strengthening in the technology and communication sectors, both leading the charge with 10.9% and 10.4% returns, respectively.
Also noteworthy: Since the six-month S&P 500 market low set on October 12, no new low has been set. According to Bespoke Research, since World War II, there have been 13 instances where this occurrence took place. What is interesting is that other than the year 2001 (post tech wreck), performance across the board was positive twelve and 18 months after the new low. There are hiccups, of course, as this month has certainly proven. In the past several days, we’ve seen jobless claims once again top estimates and the Philadelphia Fed Survey drop to its lowest reading since the depths of the COVID pandemic (in contrast to a solid New York survey earlier in the week).
At play now are an old and a new wrinkle to the market conundrum. First, the old: Investors are still reading (or trying to read) the Fed’s positioning on further hikes that will play on the markets the first week of May. Second, the new: The upcoming government debt ceiling crisis will be a face-off between short-term Washington gamesmanship and potential long-term damage to the markets. This is a likely topic for next month’s market perspective article.
At this juncture, though, the markets are in an interesting place. Through April 20, again despite the market swings and conflicting Fed governor speeches, the broader markets have settled into support levels comfortably above their 20-, 50- and 200-day moving averages—at least for now. While not limited to the examples below, the NASDAQ, S&P 500, and the overseas MSCI index and EAFE have been rather resilient, likely reflecting investors’ optimism beyond today’s economic travails.
This is also based on an aggressive idea of a Fed hike/pause/pivot/cut strategy or any combination. Having witnessed it over the past 13 months we know the Fed expectations pendulum will continue to swing between optimism and pessimism as data becomes available. We also know that the economy is slowing, and the past two weeks of data have been clear about retail sales slowing, job growth moderating, and manufacturing indicators at depressed levels. In addition, we have also witnessed the Fed jumping in to quickly strengthen against a potential regional bank failure. Clear signals exist showing that the rate hikes are already bringing inflation levels down. Where this stops is still the question. We are sitting at a number of pivot points, though, which will likely become more telling over this next month remains to be seen.
Data Dependent
As we mentioned last month, the timing of the next (or any future) rate hike will likely depend on the next two months’ economic data. If upcoming inflation data provides no further relief, recent market momentum will likely fade quickly. And aside from the question of future rate hikes, everyone today has an opinion on the timing and/or severity of the next recession—an exercise likely implying that any recessionary impact is probably already baked into the market.
Recent economic data has already confirmed that aspects of the economy here at home have already begun slowing down. Just a few weeks ago, the financial markets were focused on the potential failure of the banking system. In the past week, earnings from financial giants such as JPMorgan, Citi and Wells Fargo proved assurances that the banking system was still intact and surviving despite investor skepticism only a few weeks prior. Without a doubt, the Fed’s quick action in floating $400 billion back into the financial system and into the Fed’s balance sheet certainly helped.
Understandably, investors remain concerned over the likelihood of more volatility in the markets. The favorite barometer of risk these days is the inverted yield curve data, and headlines this past year are reminders that extended periods of inversion ultimately “rhymes with recession.” To that end, investors have voted with their brokerage accounts, transferring $304 billion into money markets during the last three weeks in March. Add nervous small business owners who are becoming extremely cautious in both hiring and expanding and Main Street now following the lead of the average retail investor, and extreme economic cautiousness can exacerbate recession timing.
A few positives in our current situation exist, though, as some investors look beyond inverted yield curves and today’s inflation levels. While expectations for one year ahead still predict an inflation level of 4.75%, investors are expecting inflation levels to fall to around 2.8% three years down the pike. Granted, these numbers are as fluid as the survey timing, but they are indicative of a “light at the end of the tunnel” perspective.
Second, aside from the 2020 pandemic-induced “flash” recession and recovery, economic slowdowns in the past that have created hardship (and extended bear markets) are generally characterized by asset bubbles. Two examples: the tech bubble burst in 2000, and the housing bubble burst in 2007. In both cases, asset bubbles artificially inflated people’s wealth through the stock market and housing prices.
As bubbles burst, companies declared bankruptcy or were forcibly acquired (start-up companies, investment banks, mortgage companies), unemployment spiked, and paper wealth in the markets and homes was erased. The situation today is different. There are no real bubbles weighing on the economy, at least none that are least compared to prior years.
Housing markets today have certainly tightened, but despite the higher mortgage rates, demand has not been destroyed, partially as a result of disappearing housing inventory. The markets have rallied from last year’s lows but not to the level of the dot-com era of 1999. Today, the scenario that “this time is different” is plausible because, despite aggressive Fed hikes, the economic growth might not slow down as much as one would expect.
Last, this recent inverted yield curve phenomenon raises an interesting question about its current cause and impact. The premise is that today’s market environment is unique as the multitude of yield inversions were not caused in the traditional manner—nervous investors pumping money into longer-term bonds, thus driving yields downward. Rather it is a Federal Reserve-induced issue resulting from the “excessive” number of rate increases over the past 13 months, trying to tamp down inflation. Despite the cause of the yield inversions, investors think the Fed has kept short-term benchmark rates too high, and the central bank should cut rates further because the economy is slowing.
The risk, of course, in this assumption is that regardless of the reason for the current inverted yield curve (short-term rates higher than long-term rates), if the Federal Reserve keeps raising rates, further increases will damage the economy and exacerbate the odds of the feared hard-landing recession.
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