Clouds Abound Amid the Silver Linings

The last few weeks have proven critical to the narrative for the economy and financial markets, and we believe we could be at or approaching an inflection point. In the rearview mirror, things look pretty good—outside of the banking sector, which I will discuss more below. First-quarter GDP came in at a respectable 1.1%, with consumer spending growing 3.7%. Companies are also delivering better-than-expected earnings for the first quarter, with nearly 80% of companies beating Wall Street analyst expectations. However, looking ahead we’re seeing clouds building. The regional banking sector’s challenges are proving more pervasive than many assumed after the fall of Silicon Valley Bank (SVB) in March. Early indications show the credit environment tightening, and leading economic indicators look bleak. There is still a path to the coveted soft landing, particularly if the Federal Reserve (Fed) is done raising rates, but that runway continues to shorten. We expect a mild recession to begin in the second half of this year, and are positioning portfolios conservatively with an underweight to equities and overweight to defensive assets.

The positive news

On the bright side, inflation continues to decelerate, tracking remarkably close to our forecast. The headline Consumer Price Index (CPI) has now fallen to a 3-month annualized pace of 3.8%. We expect it to continue to decelerate to below 3.5% in the next three months and approximately 3% by year’s end. Core inflation—either as measured by stripping out food and energy or the Fed’s new favorite metric, the “super core,” that isolates core services excluding housing—is still sticky but expected to decelerate in line with indications from purchasing managers, the Producer Price Index, and a broader slowdown of the economy. 

The labor market is also cooling. This is encouraging given the risk that a tight labor market could result in higher wages that companies ultimately pass through into the prices of goods and services. The unemployment rate is still incredibly low at 3.5%, but job openings fell sharply in March, to a ratio consistent with 1.6 jobs per unemployed person—down from a level of 2 to start the year. The four-week moving average of initial jobless claims has also ticked up. Some air is being let out of the balloon.  

On May 3, the Fed gave its first convincing indication that it could be ready to pause its relentless rate-hike assault on inflation. While inflation is clearly not yet back to the Fed’s target, the “real” fed funds rate (the level of the fed funds rate less either the observed or expected rate of inflation) is now positive. This indicates the Fed’s policy is restrictive and will become increasingly so as inflation and the economy continue to slow, perhaps motivating the Fed to reduce rates this year. The market is currently pricing almost a full percent of rate cuts before the end of the year. This seems aggressive absent a clear recession,  possibly including meaningful job losses that are not easy to discern at the moment. (See our thoughts on the recent Fed meeting.)

Please see important disclosures at the end of the article.