Markets pause as attention returns to fundamentals

Thoughts

• Equity markets were little changed in a volatile week, though the S&P 500® Index managed to extend its winning streak to three weeks. Markets have been resilient given the war in Ukraine, continued price pressures, and uncertain global economic outlook, with investors’ “buy the dip” mentality driving equity returns. Since the low in mid-March, the S&P 500 cut its year-to-date loss by nearly two-thirds to less than 5%.
• The yield curve inversion continues to be the focus of investors, triggering conversations around the timing of the next recession. The 2-year Treasury yield exceeds the yield of the 10-year by 0.04% (2.42% vs. 2.38%). Since the 1980s, each recession was predated by an inversion in the yield curve, and each time the yield curve inverted except for one (a brief period in 1998 during a mid-cycle slowdown), a recession ensued. While the track record is a strong predictor of a recession, there is no indication of the timing of a recession, which has averaged over 15 months in the past. Also, since 1988, the average return for the S&P 500® Index between inversion and the market peak was nearly 30% and took almost 18 months.
• Historically, the yield curve inversion has meant that the fuse is lit for a recession. But the timing of a recession is impossible to predict at this stage. Investors would do well to position themselves as if we’ve entered a late-cycle environment. While it is way too early to become defensive, shifting incrementally to a more conservative strategy makes sense. In this environment, quality trumps momentum-based growth.

News

• A brief inversion of the yield curve has investors increasingly nervous about a recession given the historic predictive power of the metric, though the Fed released a paper arguing that term spreads are not a valid measure of an impending recession. Economists generally agree that the odds of a recession in the next year are low (~20%) but are mixed on the odds for 2023. High-frequency data measured by the NY Fed shows growth trending at nearly 5%. Manufacturing surveys reflect a strong but slowing rate of growth, with March ISM Manufacturing at 57.1, down from February’s 58.6, with new orders down to 53.8 from 61.7. The commentary continued to reflect the complexity of strong demand against difficult supply chain and pricing pressures.
• The minutes from the March FOMC meeting will be released on Wednesday, perhaps giving an indication of the timing of balance sheet reduction. A formal announcement is expected at the May meeting, with some expecting a more aggressive quantitative tightening than in the previous cycle, with a runoff expected to be between $60-100 billion per month, ultimately shrinking the balance sheet by $2.5 trillion. The shift in the yield curve is, in part, due to this likelihood. Fed officials continue to express a hawkish outlook, setting the stage for a potential 0.50% hike at the May meeting. The Fed Futures curve currently embeds a 75% chance of a 0.50% hike in May, up from 0% a month ago. By year-end, the curve embeds a 75% chance of 10 or more total hikes for the year, a sharp increase from expectations a month ago, when the median was at less than five hikes.
• The end of the first quarter sets the stage for earning season. The current consensus estimate is for growth of just 5%, down from 31% in the fourth quarter due to more difficult comparisons, inflationary pressures, and the slowdown from Omicron. This would be the slowest growth since 4Q00. Estimate revisions have stalled, with the current estimate lower than what was expected last October, as cost pressures limit margin expansion. Growth may be strongest for energy, technology, and industrials, while financials, consumer discretionary, and communication services should decline. Wall Street analysts remain overwhelmingly positive, with the most “buy” ratings on S&P 500 stocks since at least 2010.

What to Watch

• Economic data is light this week, with durable goods on Monday, PMI and ISM non-manufacturing on Tuesday, and consumer credit on Thursday. The minutes from the recent FOMC meeting are set to be released on Wednesday.