Stocks fell Friday following a weak earnings report from Adobe#. Actually, results were in line with estimates and company management reiterated guidance. But when a stock sells for 30+ times earnings and doesn’t give investors an upside surprise, you get the reaction that Adobe got on Friday, namely a drop of 14%. Another headwind was rising bond yields in front of this week’s FOMC meeting. Sour inflation data last week cemented the conclusion that this is not the time to lower the Fed Funds rate. Maybe May? Not likely without a dramatic change in the pace of declining inflationary trends.
Over the past several months, the market has been concluding that the odds of a soft landing are rising while recession fears fade. Persistent growth has surprised most observers. Reasons given are various. Some suggest pent-up savings lasted longer than originally thought. Some attributed the better-than-expected numbers to surging immigration. But even given the strong data, there are clear signs growth is slowing. Home resales remain in the doldrums. Car dealers are rebuilding inventory. In some segments, notably EVs, there is too much inventory. Lower income consumers show signs of being tapped out. Both credit card balances and defaults are rising. Ditto for auto loans. Lenders react by tightening lending standards. While rising stock and home prices help the more affluent, those who don’t own their homes or don’t participate in the stock market only see tight money, expensive credit, and more inflation. While inflation may be receding, as I noted Friday, for those who rely on credit to support their lifestyle, the cost of high rates can be particularly painful.
Declining growth doesn’t equate to recession, but is the bottom reached before growth turns negative or not? We don’t know the answer. What we can surmise is that as growth slows, assuming present trends continue, investor fears of recession or even stagflation will rise. If the unemployment rate rises further above 4%, it will leave the Fed in a quandary. What comes first, the restrictive needs to force inflation toward 2%, or the need to support full employment? There may come a moment when the Fed will have to choose. Being a Presidential election year, politics enters the equation despite Fed officials’ protests that its actions have been and will be apolitical. During and after the State of the Union address, President Biden all but promised future cuts. The market agrees, at least for now, with only a 3% probability that there is no rate cut before the election. But making any decision based on what the futures market says six months out is pure folly.
The truth is no one can say definitively whether growth will bottom above or below the zero line. For a year, economists have wavered as to whether the end result will be a soft landing or recession. What everyone agrees on is that if there is to be a recession, it will happen later than originally predicted, as the economy has been supported by excess pandemic savings, robust Federal spending, and rising immigration.
What we know today is that the excess savings are rapidly dissipating. As for Federal spending, this being an election year, incumbents on both sides of the aisle will continue to spend as they seek reelection. As for immigration, all sides talk of limiting it, while at the same time, no one is taking any concrete steps to slow it down. How long will it take before Haitian refugees figure out the route to the U.S. is through Mexico? And will those refugees be those seeking asylum from gangs or gang members? Undoubtedly, there will be rising pressure this campaign season to police the border but no one knows how under current law.
Where does that leave markets? On the bond side, markets are adjusting to the notion that rates will stay higher for longer and the likelihood that inflation will remain more persistent than expected just a few months ago. Yield curves remain inverted. To bond investors, the threat of recession hasn’t gone away. At the same time, although credit spreads have widened a bit, they are historically very low. Markets are not fearful that lower quality bonds offer any perceived credit risk. In that regard, the bond market is voting against the likelihood of recession.
On the equity side, the key determinant will be first quarter earnings reports that will start being released in mid-April. The numbers themselves are likely to be pretty good. GDP is still rising and companies still retain some pricing power, particularly when it comes to services. But away from the Magnificent 7, profit margins fell in the fourth quarter. The key this coming quarter will be centered on what management has to say for the quarters ahead. In an economy where growth is slowing, and overseas, perhaps already in recession, don’t expect too many exuberant forecasts. April is normally one of the best months of the year for equities. That is particularly true within a robust economy facing strong growth ahead. It isn’t always true in times of deteriorating fundamentals. Right now, the logical expectation is a mixed bag. There are plenty of pockets of strength. AI spending continues to be very robust. New home sales are strong. Infrastructure spending is rising. Expect that to continue in an election year. Insurance companies are benefiting from higher rates and some moderation of catastrophic losses. Venture money is starting to flow again in the direction of biotech startups. At the same time, the auto business shows signs of slowing as does manufacturing. Some inventories are already swollen. Overseas demand is weak, particularly in China. China’s response is to support export growth, often at government subsidized prices. The economic war between China and the U.S. will likely escalate this year. China is the political bad guy that both sides of the aisle will be eager to attack.
While bitcoin prices are a bit off their highs, there are still few indications that the pace of speculation is decreasing. Another poster child for speculation will be the market’s response to Reddit’s IPO scheduled for Thursday. Reddit is the social media platform that was favored 2-3 years ago by neophyte investors eager to buy GameStop, AMC Theatres, or Bed Bath & Beyond. Those same investors will undoubtedly gravitate toward this deal. Reports suggest it is 5x or more oversubscribed. We have seen this movie script before, where robust demand for a well-recognized name leads to a fast start and a dubious finish. Do you remember Peloton or Beyond Meat? When Reddit starts taking users and Advertisers away from Facebook or Instagram let me know.
Thus, the setup today is for more speculation, lower growth and a persistent inverted yield curve with rates edging higher along the entire curve. That doesn’t sound like a great entry point to me.
Today, Queen Latifah is 54. Former Olympic speed skater Bonnie Blair is 60. Former Miss America Vanessa Williams is 61. Finally, John Kander is 97. Along with Fred Ebb they wrote the music for a string of Broadway hits including Cabaret and Chicago.
James M. Meyer, CFA 610-260-2220