April 11, 2023

There seems to be a dichotomy between the bond and stock markets.  Bond traders are signaling a hard landing (and a quick pivot by the Federal Reserve “Fed”), yet the stock market seems to continue to project a soft landing.  Recent macroeconomic data points have been decisively more negative, however, tipping the scales in favor of the bond market’s interpretation.

We saw the first cracks in the labor market last week with a big drop in JOLTS (Job Openings and Labor Turnover Survey), a disappointing ADP report, big upward revisions to jobless claims, a weak Challenger hiring survey, and nonfarm payroll growth that was roughly in-line with expectations, but slowing.  Classic ISM readings were also weaker than expected with manufacturing dropping to 46% and services falling to 51% (below 50% indicates contraction).  In the past two weeks, the Atlanta Fed’s 1Q GDPNow estimate fell from +3.5% to +1.5%.

This was all happening before the effects of the banking crisis are felt. Bank deposits have plunged in the past month, and bank loan officers are tightening credit standards and raising pricing while loan demand weakens.  The banking crisis is evidence that the Fed’s aggressive tightening campaign is having an impact and will likely lead to a further constriction in credit availability, hurting small and medium size businesses the most.  It is highly doubtful therefore that we will be able to avoid a recession.

Inflation continues to moderate, but that bodes ill for corporate profit margins.  First quarter earnings reports will likely confirm we’re already in an earnings recession and profit forecasts, especially for the second half of the year, are at risk.

In our view, market risk remains elevated with equity valuations full (S&P 500 at close to 19x forward EPS), earnings estimates falling, investor sentiment complacent, and banks under stress at the same time that the Fed continues to tighten, raising the risk of a hard landing.  Meanwhile, there has been no progress on the federal debt limit with both sides seemingly entrenched and unlikely to compromise unless prodded by some messiness in the financial markets.