April 24, 2023

The stock market has been remarkably calm in the face of hawkish Federal Reserve (“Fed”) speak (confirming another hike in May is likely), weaker economic data, cooling inflation, and the biggest bank failures since the Global Financial Crisis.  The calm likely reflects investors’ relief that there has not been any additional bank fallout since the Fed’s successful intervention.  Additionally, first quarter earnings so far have been better than expected.

Excess liquidity has likely contributed to stubbornly elevated spending, inflation and risk asset prices.  However, shrinking bank deposits/M2 money supply and constricting credit availability suggests the Fed’s aggressive tightening campaign is beginning to have an impact and may portend an imminent recession.  According to the minutes of the FOMC’s March meeting, the Fed’s staff seems to agree.

A breakout in jobless claims may be signaling a turning point for the economy.  A variety of headwinds point to a coming storm for the U.S. consumer:  (1) tax refunds are down materially year-over-year, (2) the recent expiration of enhanced STAR benefits (food stamps), (3) an estimated 3+ million people people coming off Medicaid due to eligibility redeterminations, and (4) the student loan moratorium likely comes to an end this summer. This is all coming at a time when excess savings are dwindling, layoffs are accelerating, and bank lending is drying up.

Inflation is moderating, though labor-intensive core services ex housing remain elevated and sticky, keeping pressure on the Fed.  Eroding pricing power along with sticky wages bodes ill for profit margins.  First quarter earnings, while still early, have surprised to the upside – thanks mainly to the big five banks, which exceeded estimates by more than 15%, offsetting the rest of financials which missed by 2%.  We are now heading into the meat of the earnings season which should confirm we are in an earnings recession with further downside risk, particularly to the back half of the year.

In our view, the stock market remains vulnerable with valuations full, earnings estimates falling, investor sentiment complacent, and banks under stress at the same time that the Fed continues to tighten, raising the risk of a hard landing.  Meanwhile, there has been no progress on the federal debt limit with both sides seemingly entrenched.  This is unlikely to be resolved without some market volatility in the coming months.