April Private Client Letter - Recession Risks Continue to Rise
/The most significant challenge for the U.S. economy has shifted from an uncertain path for monetary policy to a potential banking crisis and associated issues connected with tightening credit conditions.
The supply of bank credit is an important driver of macroeconomic outcomes and a contraction in credit availability serves to further slow already decelerating economic activity. Banks will likely raise lending standards in response to the current set of problems and the pace of new loan origination, for businesses and consumers alike, will decline.
Last year the Fed delivered one of the most aggressive tightening cycles in history and raised rates by an additional 0.25% at their March meeting. Now, the problems currently impacting certain parts of the banking sector are the equivalent of an additional round of monetary policy tightening. Some analysts estimate the anticipated shift in credit conditions could be equivalent of 50 to 150 basis points of policy hikes.
We believe U.S. banks are relatively well-capitalized and do not expect the type of “contagion” that could trigger a large-scale crisis. Still, serious questions remain. Shockingly, it has been reported that the bank stress tests only “stressed” banks up to a 2% Fed funds rate – even as the Fed raised the Fed funds rate to 5%. If true, the failure to test bank balance sheets above a 2% Fed funds rate was a colossal mistake and additional fallout in the banking sector remains a distinct possibility.
The banking problems are a reminder that risks will remain elevated for as long as interest rates remain high. A pending recession now appears inevitable in our view. Even as it is now likely the Fed is closer to ending rate hikes than they would have been otherwise, inflation remains a serious problem at three times the Fed’s target level. The way we see things is that interest rates are likely to remain at their peak levels for at least several more months.
The Fed recently reported that the M2 measure of the money supply dropped 0.6% in February. This represents a drop of 2.4% from a year ago, and a decline of 5.0% annualized rate from the peak in July. While we believe the enormous COVID surge in M2 was largely the cause of record high inflation, this contraction in money supply (the largest drop since the Great Depression), is not a good sign for economic activity in the year ahead. Money remains the fuel on which the economy runs, and this decline is consistent with our view that we’re headed for a recession.
The U.S. manufacturing sector fell further into contraction territory in March with the lowest reading since the early months of COVID and, before that, the end of the Great Recession in 2009. The Conference Board’s Leading Economic Index (LEI) is down over 3% in the past six months and the yield curve remains significantly inverted. These indicators, along with the housing market’s slowdown, are all classic pre-recession indicators.
While most analysts expect GDP growth of 2% to 3% in the first quarter of 2023, the Fed recently lowered its full year projection for growth to only 0.4%. If the Fed’s latest projection is to prove correct, the economy must average negative growth over the next three quarters. In other words, even the Fed itself is now forecasting a recession.
As I have observed in recent communications with you, it takes at least six to nine months for the full effects of monetary policy to be felt through out the economy. This lagged impact suggests that we are currently experiencing only half of the Fed’s interest-rate policy effects. Lower overall economic activity is still developing, and we believe corporate earnings estimates will move lower in the months ahead.
Whether it is troubling developments in the banking sector, stubbornly high inflation, or downward pressure on corporate profits, risk is clearly asymmetrical to the downside. Accordingly, we remain cautious about equities in the near-term as recession risks are rising. As we have said previously, market conditions could get worse before they get better.
Remarkably, the S&P 500 rose 7.0% in the first quarter while the technology heavy NASDAQ Composite index surged 17% higher. Even the major bond indices registered modest single digit returns as expectations for further Fed rate hikes have moderated. Using the S&P 500 as an equity proxy and the Bloomberg Aggregate bond market index as a bond proxy, the traditional 60/40 portfolio has rallied over 9% over the last two quarters. Still, these gains appear fragile in the current environment.
If there is a silver lining to all of this, it is that the end of the rate-hike cycle may be near and investor sentiment has been near record lows for most of the past year (typically a contrarian indicator). The moment the central bank signals that they are finished raising rates, households and businesses will have significant cloud of uncertainty removed. Historically, this can represent a turning point for the economy and provide a sustainable boost for equity and bond markets.
John E. Chapman
Chief Executive Officer / Chief Investment Strategist
April 2023
