Weekly Thoughts

The Consumer Price Index came in at 4.9%, modestly cooler than the 5.0% expectation and the 10th straight month of improvement. The debate is not settled whether the Fed will pause or continue the rate hike path and the ramifications are significant for economic growth as well as stress on banking system. Still, the disinflation path continues and our expectation of a 3 handle on inflation by the end of this year remains in place.

Last week market angst increased over the debt-ceiling impasse. A meeting between President Biden & House Speaker McCarthy yielded no progress as the two sides are showing no movement. We have lived through this song & dance multiple times and thus the sanguine attitude that this will be resolved is logical, but all acknowledge that it likely will go down to the wire and lead to jittery bouts of volatility. We have long stated and possess evidence to back up the contention to keep politics out of investing and only examine how policy may impact the economy and thus markets. Nonetheless, the low probability of a US debt default, even a technical short lived one, would be a devastating outcome.

Assuming avoidance of a self-inflicted catastrophe, the bottom line for capital markets comes down to how much growth slows. It is not debatable that GDP is declining and leading indicators provide evidence it has further to slow. A problem is that while inflation is heading in the right direction, it remains high enough for this Fed to remain resolute. Core inflation was 5.5%, in line with expectations. As discussed in previous essays, shelter costs are a problem, but the lagging computation method needs to be included when looking forward. This is being underestimated by this FOMC and with 500bps of tightening working through the system, we are concerned that the magnitude of hikes, even if a pause is imminent, will hit a slowing economy hard.

We hope the Fed emphasizes a measure they have been highlighting, ‘core services inflation excluding shelter’ which rose at the slowest pace in nine months. Additionally, the rise in jobless claims over the past month to a one-year high suggests the tight labor market is softening, meaning wage growth should ease as well. While so much focus is on the recession or still hoped-for soft-landing discussion, one should not ignore that bank credit turns negative during recessions. It is imperative that investors do not underestimate the impact of the banking crisis. Regardless of how this plays out, the decline in bank credit is upon us and will make growth slower than it otherwise would have been in this cycle.

It is undeniable that earnings in Q1 have performed reasonably well; like employment, that gives hope the economy can survive the Fed’s efforts to choke inflation without a recession. With liquidity shrinking, credit tightening and equities still at high valuations, a market explosion higher would be a contrarian’s dream as the most ‘predicted recession in history’ is more likely. We take the view that whether we have a technical recession or somehow skirt by, earnings will do well to only decline by a modest amount as opposed to the typical double-digit walloping in a recession. That is the scenario for a volatile market but one where it does not retest the October lows.

In the coming week, key economic releases include housing data and information on retail sales growth. Multiple Fed governors are speaking but we expect them to largely follow the playbook stating inflation remains too high but obstacles to growth have emerged; a line that allows them to tighten or pause and leave us no new clues for the next meeting. Focus on rates in the market, especially the two-year note as history shows that the market price often leads the Fed.?