April 2024 Markets Update - The US Economy is Still Resilient, But at Some Point this Year we Continue to Predict a Deflationary Recession is Ahead
Oliver Loutsenko
Head of Asset Allocation Research | Founder & CEO | Financial Markets Strategy
Global Asset Performance Overview Heat Map
Current State of the US Equity Market
While our longer-term thesis on risk assets and the US equity market hasn’t changed, we would concede the S&P 500 is more likely than not to rally until 2Q24. Our thinking is almost exclusively due to the US economy still growing. The latest GDP estimate for 1Q24 from the Atlanta Fed is +2.3%. Additionally, market participants have proven repeatedly valuations aren’t of much concern, inflation re-accelerating isn’t a reason to be bearish, banking failures don’t matter, etc. – basically the market’s psychology seems to be similar to the spring and summer of 2008 – so absent serious economic disappointment, we think there’s a higher likelihood US large-caps will continue their choppy rally through 1H24. That said, the S&P 500 is currently at 5255 and the CAPE ratio is 30.8. So even in a growing economy, we don’t see much probability of a truly enthusiastic rally like in the summer of 2008 and feel like another +4% to +5% could be more reasonable. That would put a price target range of between 5455 – 5520 at the end of 1H24.
To be clear, we view that near-term outcome as the most probable, being cognizant of the mentality this market has shown a consistent pattern for and again the fact that the US economy is still growing, however that near-term is beyond a tertiary concern to us. If anything, the short-term picture in the equity market is a distraction from the much bigger picture ahead. The valuation data compiled below the S&P 500 is just the starting point to why we disagree this environment is anything like that of a secular bull market. It also completely debunks the narrative that this market is somehow priced for recession. The historic CAPE ratio for the S&P 500 also shown below confirms the last bear market ended with the highest CAPE ratio - by far - thereby presenting substantially elevated market risk to cyclical mega-cap equities.
Now looking past 1H24 at the bigger picture, below are our weightings for the S&P 500 by segment. We began the year the most overweight on Communications, followed by Health Care, Materials, & Industrials. Worth noting Communications are leading all 11 S&P 500 segments. We’re modifying our weighting based on our assessment that market participants are beginning to transition out of cyclical and high growth segments and into interest rate sensitive segments that benefit from rate cuts. Our research shows Utilities & Consumer Staples to be the two most interest rate sensitive segments, which is why we weren’t surprised to see them suffer during the rate hiking campaign. Currently the market is pricing in rate cuts as early as June, investors appear to have appetite to get ahead of them and once they do come, that should be even more reason to be bullish. So if you have to be in the S&P 500 - and many investors feel like they do - below are our current segment weighting. Kindly note the current S&P 500 segment 12m Fwd P/E ratio's relative to the longer-term 25yr Average Fwd P/E's in the chart directly below, as that shares additional clues regarding the rationale for our segment analysis.
While the below chart shows another reason to be very wary of high growth mega-caps, we would also urge against the temptation to get too deep into the Russell 2000, even though the valuations might seem compelling. Small-cap fundamentals have been under immediate and rapid fire from the US Fed’s hiking campaign and the Fed has stayed ‘higher for longer’, giving small-caps absolutely no relief. Unlike some large-cap segments that could outperform in a recession, consumer staples being the most popularly known and I’d argue Utilities could have a very good chance particularly in this cycle, small-caps don’t really have that luxury. I’m obviously not saying there are zero small-cap equities that will outperform in a recession, but you have to really pick the individual stocks at that point. The Russell 2000 got clobbered. Also secular bull markets always start with small-cap leadership largely because they get beaten down so badly on the way down. In our view, you’re much better off in defensives and non-cyclical parts of the S&P 500.
Our Base Case Continues to be a Recession from the Delayed Lag at Which Monetary Policy Operates
I made the chart above the cover of this newsletter because I feel it touches on the most critical part of what we expect to come, as well as what many who actively follow the market may not have a comprehensive understanding of, for completely understandable reasons by the way. The impact on the broader US economy from the +550 bps hiking cycle the US Fed engaged in over 18 months is yet to scratch the surface materially in terms of lagged effects.
The chart shows the 30YR US Treasury yields relationship to the ISM prices paid component. Using a 2YR rate of change, a 2YR lag, and inverting the yield effectively shows that higher interest rates lead to deflation. In this case, it’s suggesting we should expect quite severe deflation, after a period of lag. That’s the whole premise of the lagged impact of rate hikes. While consensus believes it, we absolutely disagree the one-time monetary policy lag doesn’t adversely impact the US economy is coincidentally during the course of the most aggressive hiking campaign in US Fed history. We feel more than safe having that as a base case, though we’re still unclear on the timeline, but the above chart really sums up why we expect the outcome to be a deflationary recession for the US economy. Based on the chart we’re talking about a two-year lag period of when we first feel the deflationary effects of monetary policy. It could easily be an extra 6 months in this cycle, give or take a few months. But for there to not be any material impact to the US economy from such an aggressive hiking cycle when it’s happened every other time – including the one time a “soft landing” was achieved – seems too distant of a possibility.
You could make similar charts for data in retail sales, employment, consumer, housing market, etc. They all effectively would show after a period of lag, when interest rates drastically change there is a deflationary effect to that particular area of the US economy.
H/T: Francois Trahan, M2SD In full disclosure, I made that above chart with my color preferences and titled it, etc., but I got the actual broader idea from following his work on interest rates. Personally I think it's a little odd how some people actually go out of their way not to give credit.
What an “It’s Different This Time” Outcome Would Really Mean
I’ve said it many times before and I’m happy to repeat it: unprecedented outcomes in financial markets happen and we’re keenly aware they’ll happen again. However, when we talk about an unprecedented outcome materializing, we should really be clear about how many different outcomes would need to be pieced together for "no landing" to be achieved. ?
Those were ten things I genuinely knew off the top of my head from looking at this market for long enough. I’m certain there are plenty of other statistics that would make the US economy avoid recession unprecedented. The yield curve inversions might be repetitive but I listed those because the Federal Reserve looks at both. Regardless, what that tells me is unless there’s been a very serious structural change to the entire makeup of the US economy, the overwhelming base case continues to be recession. I didn’t even add a financial crisis in progress because it’s not specific enough, but can anyone recall a time when we know we’re going to have more banking failures, billions in CRE losses that someone will need to cover, billions of dollars in unrealized losses on securities (when push comes to shove they may turn into realized losses), etc., and have a “no landing” outcome where the US economy keeps growing for years? I can’t. I’m not saying all of that is likely to happen, but I am a bit taken back by how little market risk has been priced in to this point. ?
I’ve shared all my charts laying out the above before and it’s easy enough to fact check, so I’ll share my historic recession projection model. I don’t necessarily think this is when we’ll see recession, but based on the last six cycles we’d be looking at an ETA of June 2024. I averaged the last 6 cycles from the point at which the 10YR-2YR yield curve started steepening and the US unemployment rate began to rise off its cyclical low, which came out to 13 months even. I made this last year and in this cycle that occurred in May 2023, thus putting recession ETA in June 2024. I’d put the likelihood later in the year, but we’ll see right now the economy is still growing.
Inflation Is Still Not Progressing Enough to See the US Fed’s 2% Target in Sight
While the latest reading we have for US CPI stands at +3.2% YoY & +0.4% MoM, we did get a more recent reading for PCE (Personal Consumption Expenditures), which is a separate inflation metric the US Fed typically likes to focus on. PCE came in at +2.5% YoY and Core PCE was at +2.8% YoY. Below are the relevant charts and I think there’s really just one takeaway to point out, coming from the PCE MoM contributions. For the first time in quite a while, we saw monthly inflation increasing from goods (nondurable), versus strictly services with goods contributing to deflation. It’s also possible it’s a one-off month, but something interesting to keep an eye on. The most important takeaway for us is that a strictly data-driven Fed will be even more likely to hold off on rate cuts at this juncture.
Adding up All the Evidence Shows a Very High Likelihood of a Serious Commodities Supercycle Materializing
While we’ve been bullish on precious metals and tangible assets for some time already – predominantly Silver & Gold Miners, then Copper more recently – we have reason to believe we should anticipate a broader commodities “supercycle” coming to fruition starting as early as 2H24 and continuing through 2025. Let’s start with the obvious. Anytime in history when there was skepticism in both the equity and fixed income markets, tangible assets and namely precious metals thrived. While we don’t completely discount the equity market rally, we’ve given our rationale for being skeptical. We don’t see the fundamental support to performance since the last bear market reversed in November 2022 and even don’t see any potential for a long-term improvement in the pipeline. Few would disagree we’re experiencing an ongoing bloodbath in the fixed income market. So both of those conditions are effectively met.
Now onto the reasons this bullish commodities cycle has even more potential. Gold broke out definitively above the $2000/oz mark it was stuck at for awhile, currently trading at roughly $2233/oz. This breakout occurred recently and we feel it could be due to one of two primary factors and both support a bullish thesis. Investors might be trying to get ahead of interest rate cuts, as you’ll note the high correlation of gold to the inverted US 10YR Treasury yield below prior to its decoupling this cycle. We feel if investors are already getting ahead of rate cuts by buying gold already, once those rate cuts are really within reach we could see gold take off further upward. Additionally, we believe it’s possible some investors aren’t sold on the US Fed being in a winning position in the battle against surge inflation. Conversely, we can feel confident the recent rally was not from central bank purchases as many in mainstream financial media are insisting. Central banks have been buying gold in record quantities for years now and that’s been making its way around the news for long enough. We feel strongly this is likely due to some market participants getting ahead of what’s to come. Not for nothing, not everyone has discounted the possibility of a recession in 2024 and what if it’s catalyzed by losses suffered in the real estate market? Just look at what gold did in 2008 immediately after the collapse of Lehman, AIG, etc. That was the very essence of taking off and going upward.?
Realistically in a commodities supercycle scenario, gold should do very well. In addition, there are other methods of exposure to precious metals or tangible assets that could prove to be just as valuable, if not more (in relative terms). We also see a potential bullish thesis for silver, gold miners, copper, & other ETFs with similar exposure.
Closing Thought: A Longshot, But not a Complete Impossibility
Not to get too far into this as it would likely require an article of its own, but when there’s a global economic recession, or a global financial crisis, in more recent history it’s generally been the US igniting it. However prior to that, we saw crises in Europe, Latin America, and particularly even the AsiaPac region spread into the US. We had a deeply inverted yield curve in this cycle. The US yield curve hasn’t just been a surefire prediction for a US recession after inversion in prior cycles, but in more recent times as well it’s been a good indicator for global recessions because of how many different countries buy US Treasuries. What I’m getting at is – definitely don’t take this as my base case – but both China and Japan have very questionable economic situations, to put it mildly. Could a severe recession in China or a financial crisis and subsequent recession in Japan possibly catalyze a recession in the US? We can’t afford to face negative international economic consequences like we were able to in the late 1990’s. We have an ongoing financial crisis of our own that doesn’t need further complications. Again not the highest probable outcome I’d envision by any means, but an interesting thought nonetheless.
Thank you as always for taking the time to read and participate in my monthly markets newsletter. Hope you enjoyed this week’s update and if you have any questions, feedback, concerns, etc., please don’t hesitate to email me at:
Best of luck to all market participants this upcoming week, month, & year!
Disclaimer: The information and publications are not meant to be, and do not constitute, financial, investment, trading, or similar advice. The material supplied is not intended to be used in making decisions to buy or sell securities, or financial products of any kind. We highly encourage you to do your own research before investing.
Disclaimer: Returns from ETFs do not match the index they’re meant to track on a 1:1 scale. ETFs contain shares of securities comprising a given market metric an ETF is tracking and the composition of the ETF is often not identical to the index its tracking. For example, SPY (SPDR S&P 500 ETF) tracks the S&P 500. A committee ultimately agrees on the companies from the S&P 500 included in the ETF, using guidelines including liquidity, profitability, & balance.