It’s like the start of a good joke, but we don’t know what the punch line is yet, and no one is laughing. The truth is that our economy is fragile right now. Not all of the news is bad, and some indicators are stronger than expected. Let’s take a closer look at each of our ‘characters.’
The Economy
It’s important to understand the backdrop against which we are measuring both progress and regress. One thing that is making economists wary is the struggle that banks are currently facing. Just recently, we saw it again when San Francisco’s First Republic Bank collapsed.
Consumer demand is slowing, which means the GDP in the first quarter of 2023 was a mere 1.1%. We are also witnessing mass layoffs as companies attempt to right-size themselves to meet the lessening demands. On the bright side for workers, wage gain ticked higher in Q1.
We’re also seeing recessionary signals from various sectors like the transportation industry, where freight rates are down and diesel prices continue to slide. Housing prices are softening, another key indicator that the health of the economy is in decline. And we’ve been watching as the yield curve inverts, an indicator that has a history of accurately forecasting recessions.
The Fed
One could make a case that the Fed should cut rates this year. After all, the job market is deteriorating rapidly and history has shown that it is very difficult for it to swiftly reverse course. If history has set any precedent, it’s that job cuts will gain momentum in the coming months. On the upside, inflation seems to have finally peaked, although it still runs high.
The Fed has been given a dual mandate of minimizing unemployment while keeping inflation under control, with an inflation target of 2%. They are now faced with a dilemma: further rate increases will help reign in stubborn inflation while triggering an increase in unemployment. Though labor market conditions are deteriorating significantly each month, Fed Chair Jerome Powell asserts that he will continue to raise rates to curtail inflation. Even if that means pushing the economy into a recession.
The question we’re all asking is whether the Fed will stick to its playbook. Will they do the right and necessary thing and continue to increase interest rates? Or will they conveniently change their narrative and cut rates later this year?
We believe the Fed is unlikely to cut rates while the S&P is still at lofty levels and stock prices are overvalued. On the other hand, regional banks are stressed and a cut in interest rates would go a long way in improving the solvency of the banking sector.
The Stock Market
The stock market appears to be living in its own little bubble, disconnected from reality. Valuations are wildly elevated; Q1 and Q2 earnings have come in well above expectations (especially in the technology sector) and are keeping the market on a hot streak. Value stocks can be found in healthcare, consumer non-durables, and tech.
Zombie companies with high debt won’t be able to sustain themselves in today’s high interest rate environment, but businesses that are nimble, have a product that is disrupting the industry, or possess a household brand name will continue to command a higher price and maintain healthy margins in this tough environment.
No Joke
Today’s economic climate is no laughing matter and we take our market analysis seriously. When the economy, the Federal Reserve, and the stock market ‘walk into a room,’ they paint a conflicted picture. We still expect that a recession is on the way. But how deep it will go and how long it will ultimately last remain to be seen.
