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Sometimes, markets seem to go out of their way to confound the greatest number of investors possible. This may be one of those times. Market analysts have broadly divided into two camps: those anticipating a recession and those anticipating rate cuts this year. So far, both have been wrong. Nevertheless, the market action has been our friend.
Economy
Unemployment and Consumer Spending continue to remain strong. The ISM manufacturing data remain tepid but suggest that manufacturing may have improved from a contracting condition to a more neutral situation. Should the manufacturing data continue to improve, we may need to revisit our recession forecast. Several additional warning signals are emerging. CPI has remained stronger than expected, which is squeezing household cash flows. As a result, credit card delinquencies are rising steadily, surpassing 10-year peaks.
If we are to believe the headline unemployment numbers, we would expect building wage inflation. However, the headlines are somewhat misleading. One important reason the unemployment numbers appear so good is that record numbers of workers hold multiple jobs, and the average weekly hours worked have been in a general decline since 2021. Job openings have been declining since the spring of 2022. Weakening job market dynamics are pushing back on pressures to increase wages. The consumer is under increasing stress. At some point, the consumer will need to reliquify.
In the past few years, oil prices have been subdued by government sales of nearly all of the Strategic Petroleum Reserve to create the appearance that inflation was under control.
Our cushion is gone, making us vulnerable to disruption from Middle East unrest or other supply curtailments. In our view, an oil supply jolt would sharply impact inflation, driving interest rates higher.
The yield curve has been inverted since March 11, 2022, the most prolonged period of inverted yields in history, surpassing the previous record set in 1978 (624 days). Once the yield curve un-inverts, a recession is probable.
Monetary Policy
At the year’s onset, there was a consensus that the Fed would make several rate cuts this year. The anticipated rate cuts never materialized, and markets are digesting that reality. Meanwhile, inflation has remained more stubborn than others expected. The Fed’s monetary prescription has yet to achieve its desired effect. Under this scenario, it is difficult for the Fed to lower rates. We also think a rate hike is unlikely at this time but should not be discounted entirely. Chairman Powell’s focus continues to be the 2% inflation target, which is fleeting. Sterner measures may be required to bring things back in line, but those would risk sharpening economic contraction.
Fixed Income
Interest rates have risen above the levels from the previous year. Since the investment world was focused on the thesis that rates were poised to decline sharply this year, bond yields may still edge higher. Given that we anticipate the economy entering a recession within the next year, interest rates ought to decline across the entire yield curve, especially at the short end. For this reason, investors should not get too comfortable with the higher short-term interest rates. The rates we see today may not be available in six months or a year from now. Therefore, we are gradually extending terms to maturity to mitigate reinvestment risk, particularly if rates rise.
Equities
Year to date, investors focused on a Goldilocks type of economic slowdown and easing of interest rates, which may not occur. After a nice price run-up, investors appear to be taking a breather. In our opinion, a 5% correction at this time would be healthy. Our focus continues to be on companies that run strong businesses that can grow organically by compounding Free Cash Flow and whose sales are relatively unhindered by cyclical economic slowdowns.
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Original Posted on April 25, 2024
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
