The last 18-month period has probably been the most difficult economic environment I have seen in my adult life – if nothing else for the length of time that market forces have been battling each other. As mentioned in a prior note, you are forgiven if you’re feeling some volatility fatigue. But don’t despair, good things are happening, and I think we’re closer to the end than the beginning of this unpleasantness.
My job is to help you stick to your financial plan and investment strategy through the inevitable ups and downs of markets. And not just stick to it – but stick to it with confidence and optimism. My job is always to tell you the pure, unvarnished truth as best I see it. And right now, whether you’re an optimist or a pessimist, there is plenty of evidence to support your position. It’s impossible to list every event currently impacting markets and securities prices, but I list below the larger ones that I see impacting markets.
Earnings – Good
But let’s begin with earnings. Corporate America appears to be doing a terrific job under difficult circumstances. Many experts have been calling for a plunge in earnings…and so far, it still has not materialized. It might still arrive – but first quarter earnings are nearly done and have again soundly surprised to the upside. According to LPL, 79% of companies beat their analyst estimates (compared to a one-year average of 73% and the five-year average of 77%). For now, earnings are only down 2.3% compared to the first quarter of last year. Going into earnings season, estimates were calling for a more than 7% decline. This is undoubtedly good news.
The Fed Appears to Have Paused on Further Interest Rate Hikes – Good
It certainly seems that they are pausing based on Chairman Powell’s last press conference. He held open the option to raise rates again if the data deteriorates around inflation. But his comments that he sees a soft landing helped markets rally last week. Monetary policy works with a 12 to 18-month lag, so the worst of the tightening is most likely yet to come – and it’s possible we could even see rate cuts before the year is done to reverse the tightening. The money supply (M2) has been shrinking over the last year. While I believe this to be positive, it could turn into a negative if the money supply contracts too much. The Fed has an awful track record at bringing the economy in for a soft landing, but it remains a distinct possibility.
Inflation Trend – Good
Overall inflation is clearly trending down (in line with the lags in the overall money supply). The question is whether we will reach the Fed’s 2% inflation goal prior to something larger than banks breaking.
Employment – Good
It’s tough to have a “hard landing” when employment remains strong. I understand that employment is oftentimes one of the last data points to hold up prior to a recession. But the labor market is not currently showing any material signs of weakness.
Stock Prices in 2023 – Good and Bad
While markets are generally neutral to positive so far this year, the winners have been limited to a relatively small group of stocks – mainly large growth stocks. This is not the sort of price action you like to see if we are to begin a new bull market in stocks.
Bank Failures – Ugly
Now for the ugly. It’s possible the Fed has “ring fenced” this problem, but it’s reasonable to be skeptical. Our system is based on confidence and trust, and bank failures don’t inspire either. I understand that the banks which recently failed faced unique circumstances. But there is a lot of commercial real estate that needs refinancing over the next few years. presumably at higher rates. And depositors might continue to pull funds from banks to invest in money-market funds, especially if more banks fail. Lastly, short-term rates remain high relative to long-term rates. That’s normally not a great lending environment for banks. Now, the converse is that most people will keep their money in the bank despite meager interest being paid on their bank holdings, and banks are lending at considerably higher rates. The prime rate is currently 8%.
This is one of those stories that seems impossible to predict how and when more pain will arise. After Silicon Valley Bank collapsed, the Fed made $650 billion available for lending to banks. The banks borrowed all of it, and things calmed down. Without question, banks are holding various amounts of impaired collateral – how could they not given the violent move up in interest rates? By borrowing funds, maybe they were simply protecting themselves against being the next victim of a bank run. But the cynical answer is that they’re in more trouble than we realize. The colossal oversight by regulators over Silicon Valley Bank’s failure hasn’t inspired much confidence. And remember – bailouts (i.e., setting up credit lines for borrowing) add to the money supply. More bailouts could mean longer-lasting inflation. Fingers crossed, but this story might not be over.
U.S. Debt Ceiling – Ugly
If history is a guide, our political parties will compromise and resolve this issue. But this is one of those situations that could go to Ugly on steroids quickly. A debt default simply cannot happen.
Even if we end up in recession, two things: it doesn’t mean a market crash – arguably small and mid-sized companies have already priced in a recession. They are trading at valuation levels well below large companies. Second – and most importantly – we’ve done the proper financial planning: therefore, we know we won’t need to liquidate stocks at losses to fund your goals. Recession might still be on the way, but this is perhaps the most telegraphed recession in history, and that has given companies time to prepare.
Bottom Line: Stay patient, stay disciplined, and stay invested. Recession could lie ahead, but the longer we don’t retest the October 2022 lows in stock prices, I like our chances of crawling out of this mess sooner than later.