May 22, 2023

The stock market has remained remarkably calm in the face of another Federal Reserve (“Fed”) rate hike, stubbornly elevated wages and core inflation, another bank failure, and a quickly approaching debt ceiling x-date.  Better than expected first quarter earnings (and muted revisions), along with hopes that the Fed is finished tightening, are likely the reasons.

Despite a multitude of recession signals, excess liquidity from the pandemic continues to prop up spending, hiring, and inflation, putting the much-anticipated recession on hold.  A recent paper from the San Francisco Fed estimates roughly $500 billion of remaining excess savings in the economy (down from a peak of about $2.1 trillion), or about 5-6 months at the current drawdown rate.  However, shrinking bank deposits/M2 (money supply) and constricting credit suggests the Fed’s aggressive tightening campaign is having an impact and may portend a hard landing.  A breakout in jobless claims will likely signal a turning point for the economy – but we aren’t there yet.

There is a coming storm for the U.S. consumer, especially lower-income consumers:  (1) tax refunds are down, (2) enhanced food stamps recently expired, (3) 3 million+ people are expected to drop off Medicaid this coming year, and (4) the student loan moratorium is expected to end this summer.  All this is coming at a time when inflation continues to eat into purchasing power, excess savings are dwindling, layoffs are picking up, and bank lending is drying up.

Inflation is cooling.  However, labor-intensive core services inflation remains elevated and sticky, and inflation expectations may be becoming untethered, which will keep pressure on the Fed to remain steadfast in its inflation battle.  We see little room for the Fed to begin cutting rates anytime soon as Fed Futures suggest.  Eroding pricing power and sticky wages bode ill for corporate profit margins, and thus S&P earnings remain at risk.

In our view, risk for the stock market remains quite elevated with valuations full, earnings estimates falling, investor sentiment complacent, banks under stress, and the Fed back to shrinking its balance sheet.  Plus, we have now entered the less favorable May-to-October seasonal trading period.  Meanwhile, in Washington, D.C., there has been little progress on the federal debt limit with both sides seemingly entrenched and the June 1st x-date now just over a week away.  We expect brinksmanship to increase materially this week before an 11th hour deal to lift the debt ceiling is struck.  The problem is everyone else seems to expect the same outcome, contributing to the market’s current complacency.  It seems unlikely a resolution will be achieved without a bout of heightened market volatility to spur compromise.