Evidence is showing that the U.S. economy is slowing, the tight labor market is easing, and inflation just might have softened enough to avoid another rate hike from the Fed; consequently, the vocal proponents of a “Soft Landing” are coming out of the woodwork, asserts Jim Stack, editor of InvesTech Research.
We have a few problems with that simplistic and seemingly obvious scenario. For one thing, we know that not a single hard landing (recession) in U.S. history has been forecast in advance by a poll of economists.
And secondly, history has shown that a halt in Federal Reserve tightening does not assure a “no recession” scenario. In fact, the last two major recessions outside of the Covid pandemic (in 2001 and 2007-09) both started after the Fed began cutting interest rates!
This year's performance in the major indexes seems particularly unusual for a new bull market. The 12-month rebound in the S&P 500 off last October’s bear market low is among the weakest of the past 60 years (tied with 1987). Furthermore, it has been led entirely by a small number of mega-cap growth stocks. Without its 17 top contributing stocks, the S&P 500 would be in negative territory for the year!
Meanwhile, there is significant damage taking place beneath the surface of this supposedly strong stock market. This pain is also evident on Main Street, particularly in small businesses.
The National Federation of Independent Businesses (NFIB) Small Business Optimism Index has been below its 49-year average for the last 21 months. The General Business Outlook for the next 6 months has remained near record lows for the last 18 months.
Sentiment and expectations are important as they influence if or how businesses invest. For this reason, negative sentiment can be a self-fulfilling prophecy. We’ve rarely seen these levels outside of a recession. Bottom line, small business owners are struggling and do not expect things to improve in the near future
Consumer Sentiment is also crucial to watch as its recent rebound seems to be running out of steam. Consumer Sentiment today is at a level typically only seen in recessionary scenarios. If this indicator has any true predictive power regarding future consumer behavior, a soft landing is becoming more and more unlikely.
A soft landing becomes more elusive when we take a closer look at the housing market. Similar to consumer and business sentiment, homebuilder confidence is a crucial indicator to follow as it takes the pulse of current attitudes and can be an excellent predictor of future housing activity.
Home prices have surged by nearly 60% over the past five years, putting a major strain on affordability. This problem has been exacerbated by rising mortgage rates, causing the average mortgage payment to increase by 134% since early 2018. This is perhaps the most unaffordable time to buy a home in U.S. history!
Over the past year, we’ve expected inflation to retreat from its historically high level. But we also stated that inflation pressures would be more stubborn than many on Wall Street believed. After easing to 3.0%, the Consumer Price Index (CPI) has increased for three consecutive months and is now at 3.7%. Furthermore, measures of underlying inflation have started to reaccelerate.
With higher inflation persisting, yields on the 10-year Treasury have surged to 16-year highs as investors come to grips with the Fed’s (and our) “higher for longer” stance. Many factors led to such a large move in bond yields, but the fact remains that consumers, businesses, and homebuyers are all feeling the pain of significantly higher borrowing costs. This can be dangerous for the stock market and economy, especially in today’s interest rate-sensitive environment.
Our cautious outlook has been based on many different macroeconomic and technical indicators, one of which is the persistence of an inverted yield curve.
In March 2022, the Fed began one of the most aggressive monetary tightening cycles in history and in October, the yield on 3-month T-bills exceeded that of 10-year Treasuries. Since 1960, every yield curve inversion but one has preceded a recession.
In terms of duration, inversions that lasted over 100 trading days ended in painful bear markets, with an average loss of 45%! Today’s yield curve inversion is the longest on record and is unlikely to be resolved without major repercussions.
Even if the bear market doesn’t immediately reemerge, today’s environment presents far too much risk to be fully invested, especially when cash is yielding over 5%.
We have reduced our equity allocation to 45%. Over the past 20 years, we’ve recommended being less than 50% invested only a few times: the unwinding of the Tech Bubble, the 2008 Financial Crisis, and last year’s bear market. Needless to say, now is the time to be careful.
