- Hot economic data in Q1 ignited concerns that interest rates will remain higher for longer.
- The collapse of Silicon Valley Bank and several other regional banks gave rise to concerns about the health of the US banking system and contributed to equity market volatility during the quarter.
- Several fundamental indicators continue to point to recession later this year which may contribute to equity market volatility in the near term as earnings decelerate.
- A recession would allow the Fed to pivot to easier monetary policy and looser financial conditions, which would bode well for equity markets going forward.
The odds of a soft landing for the US economy narrowed significantly in Q1 as economic data continued to come in too hot and markets began to fear an environment of higher rates for longer. After a strong start to the year, equity markets began to falter as the risks of a Fed-induced recession rose with each new rate hike. The failure of Silicon Valley Bank and several other regional banks triggered new bouts of volatility in March as questions about the health of the US Banking system came to the fore for the first time since 2008. As markets digested the implications of a beleaguered regional banking system and tightening financial conditions on economic growth the Fed, seemingly unfazed, continued to tighten. By most metrics, the US economy is due for a recession. However, as we learned from the 2020 downturn, which turned out to be nothing like the disaster economists predicted, it is the policy response to a downturn that ultimately determines the outcome.
Many market participants take comfort that, despite a wild start to the year, certain parts of the market have shown remarkable resilience, ending the quarter with solid gains. The job market is healthy, the economy is growing, and there appears to be little risk that the bank failures of the first quarter could metastasize beyond the risk management mistakes that were unique to their downfall. Further, after a brutal year for both bond and equity markets in 2022, valuations are unquestionably more attractive than they have been in a while.
These sentiments may very well amount to whistling in the dark, a suspended disbelief that this time will somehow be different. For the fact remains that the yield curve has been an excellent predictor of recessions in the past, not because it is a good technical indicator of downturns, but because it is essentially a transmission mechanism of Fed policy. An inverted yield curve – one in which short term bonds yield more than long term bonds – has the effect of reining in demand by making borrowing more expensive. Relatively higher short-term interest rates draw money out of risky assets into higher yielding safe assets, reducing the amount of capital available for investment. An inverted yield curve also limits banks’ willingness to lend. The longer-term assets on banks’ balance sheets are yielding less than what banks are being pushed to pay out on their short-term deposits, which limits the net interest income they can generate by making loans. As a result, loan growth typically slows during periods when the yield curve remains inverted.
This dynamic has given rise to the expression that the bond market predicts recessions while the equity market reacts to recessions. Bond markets have signaled economic stress well ahead of equity markets before every recession since WWII. Typically, company earnings decline by at least 15% during a recession. Yet, entering 2023, analysts’ earnings expectations remained in positive territory. Consensus expectations for a double-digit gain in earnings this year simply look too optimistic given the economic deceleration in play and the relentless quest by the Fed to crush inflation expectations at the expense of jobs and economic growth. More likely, we expect earnings to contract moderately (-10%) compared to 2022. This would indicate more stress for equity markets in the near term.
As gloomy as that might sound, there is a silver lining. While equities are likely to see more volatility entering a recessionary period, several factors are setting up for a better second half of the year and a significantly improved long-term environment for equities going forward. A recession would have the effect of reducing corporate profits while lower inflation will also drag on corporate profit growth. That said, a recession that also leads to less wage pressure and, hence, an opportunity for the Fed to ease up on monetary policy would be a very good backdrop for better equity market performance going forward. While there is no bell that tolls to signal the turning point for equities, historically the unemployment rate has been a good leading indicator.
Historically, markets have bottomed out during a recession and rallied thereafter once the unemployment rate has increased on average for five consecutive months. Given how tight the labor market is right now and how committed the Fed is to fighting inflation, we might expect that inflection point to occur a bit later than average. However, we are also mindful of the fact that this is an unusually aggressive interest rate cycle; US banks are tightening lending standards for consumers and companies, money supply has turned negative year-over-year, the Fed’s quantitative tightening efforts are resulting in reduced liquidity and interest rates have been increased at one of the fasted paces in history, all of which will give the Fed some credibility to pivot from this rate cycle once there are signs it has effectively cooled the red hot labor market. The first uptick in unemployment since the Fed began tightening came in March and we would expect to see more of the same in the months to come. By August, the Fed will have enough data in hand to credibly back off its aggressive interest rate path. We believe all of this sets the stage for a positive equity market in the latter half of this year.