March 27, 2023

An abundance of recessionary signals makes an upcoming recession one of the most telegraphed ever, which has kept many strategists and investors defensively positioned (ourselves included), which may explain the Teflon-like nature of the S&P 500 in the face of troublesome developments.  The continued strength in the labor market, along with excess savings left over from the pandemic stimulus, have underpinned the ongoing resilience in consumer spending and the broader economy, leading to upward revisions for first quarter real GDP growth.  As such, it seems doubtful that the stock market will break until the labor market does.  Initial jobless claims should be the telltale sign.

A tight labor market has also kept inflation elevated and sticky, forcing the Fed to continue hiking rates at a time when banks are coming under stress, raising the risk of a policy mistake.  The bank crisis is clear evidence that the Fed’s aggressive tightening campaign is having an impact and should lead to further constriction of credit availability, especially for those small and medium size businesses who are most dependent on bank loans for financing.  Small/medium businesses are also the ones responsible for the bulk of job growth, which means a hard landing is now even more likely than before.  As such, we see further downward risk for S&P 500 EPS estimates, especially as wage growth remains relatively sticky while pricing power abates, hurting profit margins.

Thus, with the risk of recession rising, EPS estimates falling, equity valuations full, investor sentiment complacent, and now a bank crisis unfolding as the Fed continues to fight stubborn inflation, the stock market remains vulnerable in our view.