by Franklin J. Parker, CFA
- It is the Fed’s meeting week, and markets are on the edge of their seat. There has been generally a more hawkish tone from Fed officials lately, with a willingness to push unemployment higher in an effort to get inflation under control. Of course, unemployment only tends to rise during recessions, so effectively the Fed is communicating their willingness to push the economy into recession in order to tackle the inflation problem. Markets have priced-in two 0.50% rate hikes and one 0.75% rate hike by September. That is considerably more aggressive than previously thought.
- Inflation is a problem. Last week, inflation posted at the highest level in 40 years, 8.6%. This spooked markets (mainly because of the expected reaction from the Fed), pushing 10-year Treasury yields well into the 3% range. In addition, the yield on the 2-year US Treasury moved higher than the 10-year US Treasury (known as a yield curve inversion). This is a widely-followed recessionary indicator, although it is considerably noisier than the 10-year minus the 3-month US Treasury yield (which is the indicator I follow, and it is not showing recessionary signals).
- In addition to the Fed, this week we get producer prices (another gauge of inflationary levels), retail sales, and industrial production. Retail sales is an important figure: if demand in the economy begins to wane, a recession will be much more likely. Of course, most of this data will be completely overshadowed by the Federal Reserve meeting, rate announcement, and press conference on Wednesday.
The Details & Chart of the Week
I admit, this market has gotten a bit nasty.
Investors have grown very concern about ever-increasing inflation, and the Fed’s response to this problem. Last week’s higher-than-expected inflation print pushed markets over the edge.
My view has been that, barring a recession, the S&P 500 would log a low around the 3900 level. Looking at a chart of the S&P 500 (and applying some basic technical analysis), we can see that there were buyers in the 3800 range and above since at least mid-2021. Today’s break below 3800 signals that those buyers have moved to a lower price. The next level that might offer some support is the mid-3500 range—a full 6% lower than current price. If markets get there, that would be a 26% total drawdown from the S&P 500’s peak—a very rare event outside of a recession. Also working against stocks in the short term is the downward channel that has very clearly formed since the start of the year.
In short, the short-term picture looks rough, with a new possible bottom getting logged somewhere around 3500 and sometime between July and October. Of course, these short-term swings are notoriously hard to predict, and a single news item can turn the whole thing around. The Fed’s meeting on Wednesday, for example, may offer an upside surprise to markets which have begun to price in a possibly overly pessimistic view of Fed actions.
The big question is: are we in a recession, and, if so, how long would it last? My view is that we are not. Employment is still very strong, consumer demand remains high, and credit is still flowing. If this is a recession (and it might be!), it would be a very strange one. Last quarter’s GDP posting, showing a contraction, might give investors some clue as to a potential cause. Government spending is down considerably from this time last year, and that could be enough to drag the economy into a technical recession, even if the fundamentals look decent.
If this is not a demand-induced recession (i.e. fewer people working and buying things), then I still see a run-up into the end of the year. But, as I have said many times before, flexibility is key in this environment. As we get new data, we must update our view and our portfolios.
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