I know, the recession narrative has become pretty stale at this point, and I’m guessing that most people are as tired of hearing about it as I am.  But just because it’s been well advertised doesn’t mean the risk it presents is any less significant.  Without question the U.S. economy has proven itself to be much more resilient than many expected – myself included.  However, I fear this resiliency has embedded a false sense of security or better yet, complacency among investors.

I start off this week’s missive with the notion of complacency in mind because the slate of economic data we received last week revealed legitimate cracks in two parts of the economy (labor and services) that had been invalidating the recession ‘here, now’ call.  The ISM non-manufacturing index for March declined to 51.2 from 55.10 in February.  Now to be fair a reading above 50 is still expansionary, but the internals of the report suggest broad based weakness.  Moreover, this index is down from 58.3 a year ago.  One month doesn’t make a trend, so next month’s reading will be important in collaborating the weakness or dispelling this print as just an aberration.

It's the array of weakness in other data that has me leaning in the direction that the services sector is finally giving way to catch down to the rest of the economy.  The ISM manufacturing sector at 46.30 is at its worst level since the Covid lows in 2020 and has been under 50 for five consecutive months.  The read-through on last week’s labor market data was inconclusive overall, but on the margin exhibited a weakening trend.  The ADP report was soft with +145k jobs created in March versus +261k in February.  The JOLTS survey was weak as well with job openings slipping to their lowest level in two years at 9.93 million in February from 10.56 million in January.  The Challenger job cuts survey showed 89,703 employees received pink slips in March and this is up 319% year-over-year.  Additionally, we have jobless claims where the BLS went through its annual revision and show claims are running at a much higher rate than any of us thought.  Have a look at the below data showing the pre-revision jobless claims print compared to the post-revision print:

• Week of April 6th +228k

• Week of March 30th originally reported +198k, revised to +246k

• Week of March 23rd originally reported +191k, revised to +247k

• Week of March 16th originally reported +192k, revised to +230k 

That is an additional increase of 142k jobless claims inside the span of three weeks.  That is a significant change and not in a good way to a labor market data series that is considered in market parlance as a leading indicator.  Not to mention that continuing claims are up to 1.82 million from the originally reported 1.69 million which has since been revised to 1.817 million.

In a nutshell the labor market appears to finally be succumbing to the slowdown that has been underway in many other parts of the economy for some time now.  Is it a disaster? No, as the BLS employment report on Friday attests with the economy adding +236k jobs in March.  But many of the cyclical parts of the March jobs report showed deterioration.  A signal one would expect to see following the nearly 500 basis points of interest rate hikes over the past year.

Moreover, if the labor market was as tight as the 3.5% unemployment rate suggests then you wouldn’t be seeing average hourly earnings running at the tepid 3.2% annual rate over the three months to March.  Couple the contraction we’re seeing in the workweek, the weakness espoused in the JOLTS data and the hook up in initial jobless claims gives you a clear indication of increasing slack in labor demand.  However, enough strength remains in the lagging labor market data to give the Fed cover for further tighten policy if they want to continue down that path.  Fed Fund futures are pricing in roughly 65% odds of the Fed hiking rates again in the early May FOMC meeting.  There can be little doubt at this point that most central banks are either at or close to the peak of their tightening campaigns.    

Let me remind you that inevitable does not mean imminent.  It takes time and a lot of energy to turn the tide of the U.S. economy.  This causes many investors to become impatient with allowing the cycle to playout.  Our work as well has others dawning a bearish bias has been picking up signals of rising recession risk over the past six months, the fact that it hasn’t happened yet doesn’t negate the fact that we’re trending in that direction.  The precise timing of a recession call is impossible in real time, but what’s important is picking up on the conditions and signals foretelling the increase in risk.

The IMF is penciling in the weakest five-year GDP growth forecast it has in at least the past three decades.  Take this for what it is, a signpost of economic fragility.  Not a crisis, not chaos, and definitely not the end of the world, but a period in time where small problems can metastasize into big problems.  Expected weakness in world demand is a hurdle for the commodity complex even with a supportive supply curve.  Such a backdrop supports the security and strong balance sheets of mega-cap Tech regardless of them being an overcrowded holding.  Hence, we’ve seen seven stocks lift the entire S&P 500 index this year to a 7% gain in the first quarter.  But make no mistake, narrow breadth is not an indication of overall market strength.         

The market reaction to last week’s data was clear in that ‘bad news is no longer considered good news’.  Cyclical sectors were hit especially hard with Industrials down -3.37% on the week, Consumer Discretionary -2.95%, and Materials – 1.26% versus defensive sectors getting a bid – Utilities and Healthcare up more than 3%, and Consumer Staples up 0.94%.  The S&P 500 was pretty much flat on the week (-0.06%), but Small Caps were hit hard with a decline of -2.68% and the Nasdaq was the victim of market rotation as it slid -1.08%.  In the interest of full disclosure, for the first time in over a year, I did start a small position in client portfolios in the Small-Cap and Mid-Cap Indices as they’ve been sold off to the tune of roughly 7% in the past month in part given their exposure to regional banks and the deposit flight taking shape in the banking sector. 

A longer-term theme in our work is the potential for a U.S. industrial renaissance on the back of peak globalization, onshoring/reshoring and a prolonged energy transition – a theme that if correct should benefit small/mid-sized companies given their exposure to industrials, materials, energy, and the banking sector.  This isn’t a theme that you position heavy in today, but rather pick your spots to gradually build out the position during weakness over the next 12 – 18 months.  Small caps are down roughly 25% from their November 2021 peak and while I do expect they have further to fall in an economic recession, we are entering a window of opportunity to patiently accumulate and dipping a toe in after a 25% slide makes sense to me.  Let me stress once again, small sizing is imperative for now as you’ll have more opportunities to up your exposure going forward.       

Interest rates were lower across the board in reaction to last week’s data (although they are giving some of that back today) with the yield on the 10-year Treasury note slipping below 3.30% at one point.  During this most recent rally the 10-yr Treasury yield has taken out all its major trendlines where any further decline from here could very well set the stage for an assault on the August 2022 lows around 2.6%.  That would be exciting for those of us holding long-duration Treasuries, but that would also represent a target level to start stepping out of some duration exposure. 

Gold extended its impressive rally to a 13-month high of $2,040/oz and is up 12% over the past month and +25% since being left for dead by most investors last November.  A bout of consolidation seems likely for gold given the run it had, and maybe even a slight pullback into the low 1,900’s is possible.  I do think the yellow metal eventually takes out its prior record high of $2,069/oz and then from there we’re in uncharted territories as to how high it goes.

We have another big week in front of us on the data front with CPI, PPI, industrial production, and the early read on April consumer sentiment.  The March FOMC minutes will be released and a long lineup of Fed speakers are scheduled.  First quarter earnings season will get underway at the end of the week with the U.S. banks including JP Morgan Chase, Wells Fargo, and Citigroup.  According to FactSet, there have been 78 negative pre-announcements for Q1 compared to 28 positive earnings announcements (that’s almost a 3:1 ratio versus the average of 2:1).  Expectations for Q1 earnings numbers have come down with consensus estimates looking for a decline of -7% year-over-year.  If accurate this would mark the worst setback since the covid trough in Q2 2020.  Outside of the pandemic there are a couple material differences between then and now; risk-free rates were zero versus nearly 5% today, the Fed was easing not tightening as is the case today, Washington D.C. was giving money to almost everyone, and the recession was in the rear-view mirror versus on the horizon.         

Even though calendar year 2023 earnings estimates have come down from roughly $250/share to $222/share I still think they remain too high given the economic backdrop.  I suspect before all is said and done, they need to come down to around $200 and then I’d be a more aggressive acquirer of equities on the premise that a lot of bad news was discounted. 

Let me end this week’s missive with a thought on bear markets.  They are all unique whether they are driven by policy, fundamentals, inflation, or economic growth which makes them highly unpredictable.  So, no matter how much I write in any given week or how intelligent I may sound, I don’t know what’s going to happen.  This applies to everyone else as well.  That doesn’t mean that study, preparation, analysis, and an understanding of history isn’t useful (because it is), but it only takes you so far.  The bear market that got underway in January 2022 is no exception.  The S&P 500 had a peak to trough drawdown of -26.6% at its October 13th 2022 low.  That low was 175 days ago and since then we’ve experienced a nearly 17% rally in the S&P 500.

Over this roughly six-month stretch there has been no shortage of economic stress and financial woes to further trip up markets.  And while our work suggests things get worse before they get better until a new low in the S&P 500 occurs, we must work with the assumption that the October lows may have been ‘the low’.  If that ends up being the case (I have my doubts, but one must keep an open mind) then we’re looking at a bear market that has been exceptionally well-contained.  A couple things stand out when comparing this bear market with its peers.  For starters, it was a relatively drawn-out affair – spanning 315 days from peak to trough.  In comparison to other bear markets the overall drawdown has been mild and to this point has been lacking a significant moment of capitulation or spike in volatility.  The VIX has failed to push above 40 at any point in this bear market which pales in comparison to typical capitulator spikes between 50 -80.  Moreover, the recovery from the October low is also lacking much verve with its modest 17% rise in the six months following a bear market low.   

I’m afraid none of us has a definitive answer to the burning question of whether the bear market is over or not but trust me when I tell you that we’ll all learn the answer in time.  Thanks Corey, that’s as useful as tits on a bull.  We all have our views and right now our work has us in the camp that the bulk of the drama has yet to unfold.  So, stay patient, fight the understandable creep of complacency, and continue to evolve your action plan.  Perhaps the one thing I’m most confident about (which is also my biggest worry) is that neither the economy nor the stock market is going to run away to the upside before us bears can change our minds.  In the meantime, I’ll be content with the 4 – 5% yields provided by short duration bonds and cash.         

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