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Sometimes, it seems like the markets are doing everything they can to confuse as many investors as possible. This may be one of those times. Market analysts are generally divided into two camps: those who expect a recession and those who expect interest rate cuts this year. And so far, both have been wrong. However, market action has been our friend.
Economy
Unemployment rates and consumer spending remain strong. Manufacturing data from ISM remains tepid but indicates that manufacturing may have improved from contraction to a more neutral position. If manufacturing data continues to improve, we may need to reconsider our recession forecast. Several additional warning signs appear. The consumer price index remained stronger than expected, putting pressure on household cash flows. As a result, credit card delinquency rates are steadily rising, exceeding their highest levels in ten years.
If we are to believe the headline unemployment figures, we expect wage inflation to increase. However, the titles are somewhat misleading. One important reason the unemployment numbers look so good is that record numbers of workers are holding multiple jobs, and average weekly hours worked have been on an overall decline since 2021. Job openings have been declining since the spring of 2022. Weak labor market dynamics are driving To – retreat from pressure to increase wages. The consumer is under increasing pressure. At some point, the consumer will need to lighten up.
In the past few years, oil prices fell due to government sales of almost all of the Strategic Petroleum Reserve to create the appearance that inflation was under control.
Our cushion is gone, leaving us vulnerable to disruptions from unrest in the Middle East or other supply cuts. In our view, any jolt in oil supplies would sharply affect inflation, leading to higher interest rates.
The yield curve has inverted since March 11, 2022, the longest period of inverted yields in history, surpassing the previous record set in 1978 (624 days). Once the yield curve inverts, a recession is likely.
Monetary policy
At the beginning of the year, there was consensus that the Fed would make several interest rate cuts this year. The expected interest rate cuts never materialized, and markets are beginning to absorb this reality. Meanwhile, inflation remained more stubborn than others expected. The Fed’s monetary prescription has not yet achieved the desired effect. Under this scenario, it will be difficult for the Fed to lower interest rates. We also believe a rate hike is unlikely at the moment but should not be completely ruled out. Chairman Powell’s focus remains on the 2% inflation target, which is a passing target. More stringent measures may be required to get things back on track, but such measures would risk making the economic downturn more severe.
Fixed income
Interest rates rose above the previous year’s levels. Since the investment world has been focusing on the assumption that interest rates are about to fall sharply this year, bond yields may continue to rise. Given that we expect the economy to enter a recession over the next year, interest rates are expected to fall across the entire yield curve, especially at the short end. For this reason, investors should not become comfortable with high short-term interest rates. The prices we see today may not be available six months or a year from now. Therefore, we are gradually extending terms to maturity to mitigate reinvestment risk, especially if interest rates rise.
Stocks
Year-to-date, investors have been focused on the economic slowdown and interest rate easing, which may not happen. After a good rise in prices, investors seem to be taking a breath. In our opinion, a 5% correction at the moment would be healthy. Our focus continues to be on companies that operate strong businesses that can grow organically by maximizing free cash flow and whose sales are relatively unaffected by cyclical economic slowdowns.
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Originally published on April 25, 2024
Editor’s note: The summary points for this article were selected by Seeking Alpha editors.
