Same destination, but now a more treacherous path 🚧
Plus a charted review of the macro crosscurrents 🔀
After an incredibly volatile couple of days, stocks ended higher last week, with the S&P 500 rising 1.4%. The index is now up 2.0% year to date, up 9.5% from its October 12 closing low of 3,577.03, and down 18.3% from its January 3, 2022 closing high of 4,796.56.
For a moment, sentiment toward the economy began to shift bullishly on the heels of economic reports that were stronger than many economists’ expectations.
But all of that came to an end last week as concerns over financial stability emerged in the wake of two bank failures, which in turn put a spotlight on the vulnerabilities of smaller regional banks.
“Our banks analysts see a meaningful increase in funding costs ahead, which will lead to tighter lending standards, slower loan growth, and wider loan spreads,“ Ellen Zentner, chief U.S. economist at Morgan Stanley, wrote on Thursday. “We were already expecting a meaningful slowdown in growth and job gains over the coming months, and the prospect of substantial tightening in credit conditions raises the risk that a soft landing turns into a harder one.“
Economists at Goldman Sachs, JPMorgan, and Wells Fargo were also among those citing similar economic headwinds as they cut their forecasts for growth.
On one hand, these recent developments aren’t good. Jobs will almost certainly be lost as a tighter banking system means financing becomes less accessible.
On the other hand, these effects are arguably of the kind that the Federal Reserve has been aiming for over the past year.
An unplanned path to the same destination 🚧
Over the past year, the Fed has been aggressively tightening monetary policy in its effort to bring down inflation by cooling economic demand. The thinking behind this was that by tightening financial conditions with interest rate hikes, financing costs go up for businesses and consumers, which slows their spending. This eases pressure on supply and, in turn, prices cool.
For more on why the Fed is tightening monetary policy, read: The complicated mess of the markets and economy, explained 🧩
The Fed likely didn’t specifically intend for a big bank to fail, but the risk of such a thing happening was going to be elevated with how monetary policy was being implemented.
So it’s a bit ironic these undesired bank failures seem to be having the desired effect of accelerating the conditions that could ultimately lead to inflation coming down decisively.
“Ongoing pressure could cause smaller banks to become more conservative about lending in order to preserve liquidity in case they need to meet depositor withdrawals, and a tightening in lending standards could weigh on aggregate demand,” Jan Hatzius, chief economist at Goldman Sachs, wrote in a research note on Wednesday.
And just because these banks are smaller doesn’t mean they’re small.
“Small and medium-sized banks play an important role in the US economy,” Hatzius added. “Banks with less than $250bn in assets account for roughly 50% of US commercial and industrial lending…”
“…60% of residential real estate lending…”
“…80% of commercial real estate lending…”
“…and 45% of consumer lending.”
As Bloomberg Opinion columnist Conor Sen put it:
Just hypothetically, if it were possible for a large-ish bank to fail and for lending standards/financial conditions to tighten enough to knock 50bps off NGDP growth but no broader contagion, I’d say that helps the Fed achieve its dual mandate.
In other words, the unintended bank failures may be helping the Fed achieve its intended goals. It’s an unplanned path to the same destination.
And not that anyone’s particularly sanguine about what’s happening, but some are less sanguine about this take than others.
“I always laugh when people say, ‘Oh, the Fed’s policies are finally gaining traction,’” Mohamed El-Erian, chief economic adviser at Allianz, told Bloomberg TV on Friday. “Is this the way we want the Fed’s policies to gain traction? By destabilizing the banking system? By creating a credit withdrawal? By having too much damage to the economy and to jobs? You know, that's not how monetary policy is supposed to gain traction, not through financial instability.”
“So yeah, to some extent it does mean that the Fed will end up with lower inflation than would have been otherwise,” El-Erian added. “But the journey there is terrible, and it's unnecessary.”
The risk is that the emerging financial instability causes much more economic damage than what would’ve been necessary to get inflation under control.
How to think about whatever comes next 🤔
It’ll be a month or so before we start getting economic data reflecting the impact of the banking turmoil that began two weeks ago.
With that in mind, approach this week’s review of the macro crosscurrents (below) with a little caution given that most of it reflects economic activity that occurred before last week’s developments.
Neil Dutta, head of economic research at Renaissance Macro, addressed how to interpret the recent economic data in an email on Thursday:
It is true that the latest economic data are stale, but I do not believe that we should ignore the news entirely. The US economy went into this financial market shock with substantial momentum. Core retail sales in February? Strong. Building permits and housing starts? Strong. Initial jobless claims? Low. Nominal growth in Q1 is running between 8 to 9% (Real GDP tracking close to 3.5% with underlying inflation of 5%). That's a pretty sizable buffer. Looking ahead, outside of nonresidential business fixed investment, it is hard to see what goes south. Government spending and inventories have room to add in the months ahead, as an example….
Indeed, while the risk the economy tips into recession has been elevated — something I’ve been noting in TKer’s past weekly review of macro crosscurrents — it continues to be bolstered by massive tailwinds. The question is to what degree these tailwinds subside.
Related from TKer:
It's an economic quandary and the Fed sees only one way out 🧩
Reviewing the macro crosscurrents 🔀
There were a few notable data points from last week to consider:
🎈 Inflation continues to moderate. The consumer price index (CPI) in February was up 6.0% from a year ago, down from 6.3% in January. Adjusted for food and energy prices, core CPI was up 5.5%, down marginally from the month prior.
On a month-over-month basis, CPI was up 0.4% as energy prices fell 0.6% during the period. Core CPI was up 0.5% as shelter prices jumped 0.8%.
If you annualize the three-month trend in the monthly figures, CPI is rising at a 4.1% rate and core CPI is climbing at a 5.2% rate.
The bottom line is that while inflation rates have been trending lower, they continue to be above the Federal Reserve’s target rate of 2%.
For more on the implications of cooling inflation, read: The bullish 'goldilocks' soft landing scenario that everyone wants 😀.
🏡 Rents are cooling. From Redfin: “The median U.S. asking rent rose 1.7% year over year to $1,937 in February — the smallest increase in nearly two years and the lowest level in a year… February was the ninth straight month in which rent growth slowed on a year-over-year basis. Rents fell 0.3% from a month earlier. Still, the median asking rent remained 21.4% higher than it was in February 2020, the month before the coronavirus was declared a pandemic.“
👍 Expectations for inflation ease. From the New York Fed’s February Survey of Consumer Expectations: “Median inflation expectations dropped by 0.8 percentage point at the one-year-ahead horizon to 4.2%, remained unchanged at the three-year-ahead horizon at 2.7%, and increased by 0.1 percentage point at the five-year-ahead horizon to 2.6%.“
This echoes the University of Michigan’s March Survey of Consumers: “Year-ahead inflation expectations receded from 4.1% in February to 3.8%, the lowest reading since April 2021, but remain well above the 2.3-3.0% range seen in the two years prior to the pandemic. Long-run inflation expectations edged down to 2.8%, falling below the narrow 2.9-3.1% range for only the second time in the last 20 months.“
🛍️ Retail sales cool. According to Census Bureau data, retail sales in February declined 0.4% to $697.9 billion.
Excluding autos and gas, sales were flat as gains in online retail, health and personal care, groceries, and electronics were more than offset by declines in department stores, furniture, restaurants and bars, and clothes.
🏭 Industrial activity cools. Industrial production activity in February was unchanged from January levels, with manufacturing output climbing 0.1%.
🏠 Housing construction jumps. According to the Census Bureau, new building jumped 13.8% month-over-month in February to an annualized rate of 1.52 million units. Housing starts surged 9.8% to 1.45 million units.
👎 Surveys sour. Regional manufacturing surveys from the New York Fed and Philly Fed suggested business activity contracted in March.
Consumer sentiment, meanwhile, deteriorated in March for the first time in four months.
For more on the signals sent by surveys, read: What businesses do > what businesses say 🙊.
💼 Unemployment claims remain low. Initial claims for unemployment benefits — the most up-to-date of the major labor market stats — fell to 192,000 during the week ending March 11, down from from 212,000 the week prior. While the number is up from its six-decade low of 166,000 in March 2022, it remains near levels seen during periods of economic expansion.
For more on low unemployment, read: The labor market is simultaneously hot 🔥, cooling 🧊, and kinda problematic 😵💫.
🚨 Recession warning sign. The Conference Board’s Leading Economic Indexfell in February, the eleventh consecutive month of declines. From The Conference Board's Ataman Ozyildirim: "Negative or flat contributions from eight of the index’s ten components more than offset improving stock prices and a better-than-expected reading for residential building permits. While the rate of month-over-month declines in the LEI have moderated in recent months, the leading economic index still points to risk of recession in the US economy. The most recent financial turmoil in the US banking sector is not reflected in the LEI data but could have a negative impact on the outlook if it persists. Overall, The Conference Board forecasts rising interest rates paired with declining consumer spending will most likely push the US economy into recession in the near term."
📈 But near-term GDP growth estimates remain rosy. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 3.2% rate in Q1. This is up considerably from its initial estimate of 0.7% growth as of January 27.
For more on the improving economic outlook, read: Economic forecasts are getting revised up, and people aren't thrilled about it 🙃
Putting it all together 🤔
Despite recent banking tumult, we’re getting a lot of evidence that we could see a bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.
The Federal Reserve recently adopted a less hawkish tone, acknowledging on February 1 that “for the first time that the disinflationary process has started.“ We will learn more about the Fed’s evolving thinking on March 22 after the next Federal Open Market Committee.
In any case, inflation still has to come down more before the Fed is comfortable with price levels. So we should expect the central bank to continue to tighten monetary policy, which means we should be prepared for tighter financial conditions (e.g. higher interest rates, tighter lending standards, and lower stock valuations).
All of this means the market beatings may continue, and the risk the economy sinks into a recession will be relatively elevated. In fact, recession risks intensified recently with bank failures sparking concerns about financial stability.
However, it’s important to remember that while recession risks are elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs. Those with jobs are getting raises. And many still have excess savings to tap into. Indeed, strong spending data confirms this financial resilience. So it’s too early to sound the alarm from a consumption perspective.
At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.
As always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have had a pretty rough couple of years, the long-run outlook for stocks remains positive.
For more on how the macro story is evolving, check out the the previous TKer macro crosscurrents »
For more on why this is an unusually unfavorable environment for the stock market, read: The market beatings will continue until inflation improves 🥊 »
For a closer look at where we are and how we got here, read: The complicated mess of the markets and economy, explained 🧩 »
TKer’s best insights about the stock market 📈
Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.
10 truths about the stock market 📈
The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
Stomach-churning stock market sell-offs are normal🎢
Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.
How stocks performed when the yield curve inverted ⚠️
There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.
How the stock market performed around recessions 📉📈
Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.
In the stock market, time pays ⏳
Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.
700+ reasons why S&P 500 index investing isn't very 'passive'💡
Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks. From January 1995 through April 2022, 728 tickers have been added to the S&P 500, while 724 have been removed.
The key driver of stock prices: Earnings💰
For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.
When the Fed-sponsored market beatings could end 📈
At some point in the future, we’ll learn a new bull market in stocks has begun. Before we can get there, the Federal Reserve will likely have to take its foot off the neck of financial markets. If history is a guide, then the market should bottom weeks or months before we get that signal from the Fed.
What a strong dollar means for stocks 👑
While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.
Economy ≠ Stock Market 🤷♂️
The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.
Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐
…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.
Peter Lynch made a remarkably prescient market observation in 1994 🎯
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.
Warren Buffett's 'fourth law of motion' 📉
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
'Past performance is no guarantee of future results,' charted 📊
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. According to their research, 29% of 791 large-cap equity funds that beat the S&P 500 in 2019. Of those funds, 75% beat the benchmark again in 2020. But only 9.1%, or 21 funds, were able to extend that outperformance streak into 2021.
One stat shows how hard it is to pick market-beating stocks 🎲
Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 22% of the stocks in the S&P 500 outperformed the index itself from 2000 to 2020. Over that period, the S&P 500 gained 322%, while the median stock rose by just 63%.
Here’s more detail from the Conference Board: “The LEI is a predictive variable that anticipates (or “leads”) turning points in the business cycle by around 7 months… The ten components of The Conference Board Leading Economic Index® for the U.S. include: Average weekly hours in manufacturing; Average weekly initial claims for unemployment insurance; Manufacturers’ new orders for consumer goods and materials; ISM® Index of New Orders; Manufacturers’ new orders for nondefense capital goods excluding aircraft orders; Building permits for new private housing units; S&P 500® Index of Stock Prices; Leading Credit Index™; Interest rate spread (10-year Treasury bonds less federal funds rate); Average consumer expectations for business conditions.”