As we await the beginning of the reporting season, which opens tomorrow with the banks, let’s paint the macroeconomic picture we are observing now. We believe that understanding the economic backdrop can neutralize the effects of short-term market reactions to earnings surprises, thus helping investors avoid emotional trading actions while helping them to concentrate on their long-term portfolio goals.
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Mr. Market is Way Too Optimistic
At its March Federal Open Market Committee (FOMC) meeting, the Fed turned from hawkish to almost neutral in its message, excluding the previous phrase of “ongoing” rate increases, albeit adding that “some additional” policy firming may be needed. Markets, tired from ups and downs, have interpreted this as a sign that the end of its current rate hike cycle is near. The FOMC’s outlook for a “mild recession,” stated in the minutes, spurred bets – again – that the Fed will cut rates to help the economy as soon as in the second half of this year. Market participants mostly brushed off the Federal Reserve’s reconfirmation of its dedication to bringing down the still-high inflation (meaning further hikes).
The same selectivity in choosing narrative-confirming details can be seen in some reactions to the latest jobs and CPI reports. The top-line data from the reports seemingly confirmed optimistic views that the Federal Reserve is succeeding in its fight against inflation, and the markets cheered the perceived Goldilocks scenario where the inflation continues to decline without being followed by an economic crash.
The Devil is in the Details
However, the details of the reports contradict the happy-ending scenario. The job market, although cooling, is still very tight, while core inflation, which is not affected by the seasonality of energy and food prices, shows that there’s still a lot of work for the policymakers to do. Yes, the inflationary pressures are subsiding, but not as fast as the Fed would like them to.
Meanwhile, the economy is apparently weakening, with many data points confirming this fact. For instance, the Conference Board Leading Economic Index (LEI) – an aggregate measure of 10 leading economic indicators – has fallen for the 11th straight month in February, reaching levels previously seen before the 2001 and 2008 recessions. The negative contributions to the LEI readings were spread among both financial and non-financial components; this indicates widespread weakness in the economy, signifying an almost imminent recession sometime within the next 12 months.
Stocks Display Pollyanna Syndrome
What we are seeing now is a mild economic downturn engineered by the Fed to depress prices – not a disaster for the economy, but still disinflationary. However, downturns can quickly get out of hand when compounded by a banking crisis or some other unforeseen event. Everyone should hope that the economy doesn’t weaken so much as to force the Federal Reserve to pivot from its anti-inflation path and cut rates to avoid a disaster.
The problem is that stock markets may be blinded by their fear of rising rates, which scares them more than a recession, at least more than a mild one – as they are sure that what’s been at least partially discounted is in the past and forgotten. Bond markets, on the other hand, react to a spread between the short and long-term outlook, which, in turn, is a trustworthy economic indicator. So, let’s look at bonds.
Bond Markets Watch the Banks
The $24 trillion U.S. Treasury market disagrees with the stock market’s rosy outlook. The sharp gyrations in bond yields, with volatility at a level unseen since the 2008 crisis, coupled with a yield curve that is inverted all the way up to 10-year yield, are screaming “trouble ahead.” Historically, the level of uncertainty we are witnessing now in the bond markets has preceded considerable economic downturns.
The negative spread between the 10-year Treasury notes yields and those of the 3-month Treasury bills is now the widest since 1982. An inversion of these specific points on the yield curve has predicted every recession since 1969. Inversions between 2-year and 10-year Treasury yields have been less accurate economic predictors, but they are still a reliable indicator for recessions as well as bear markets in stocks.
The large and prolonged yield curve inversion (ongoing now since October 2022) is the reason behind banking sector troubles, as it has broken lenders’ traditional business model. A reversion back to normal isn’t in sight for now as for the curve to “mend” fast, a sharp reversal in the inflation trend must materialize (and we certainly hope that won’t happen, as it would be the result of an economic implosion). This means that the crisis in banks is probably far from over – and that lending to businesses and individuals will continue to contract, straining the economy further.
An Earnings Recession is Already Here
According to Factset, the number of the S&P 500 (SPX) companies that had issued negative EPS guidance for the first quarter was the highest since Q3 2019. The highest number of negative-outlook issues lie in the IT and industrial sectors. Interestingly, information technology is also the leader in positive guidance numbers, indicating the wide variety of performance among IT companies. The financial sector’s low propensity to guidance issuance is the reason for the banks’ absence in the negative guidance leaders’ league.
In Q1 2023, S&P 500 earnings are expected to decline for a second consecutive quarter. The estimated earnings decline is -6.6% year-over-year, the steepest decrease since the peak of the COVID-19 crisis in Q2 2020, after Q4-2022’s earnings fall of -4.6%. The earnings of S&P 500 companies are expected to continue declining in the second quarter of 2023 and to recover in the second half of the year. However, this outlook stands in stark contrast to economists’ forecasts for a second-half downturn. Simply put, stock analysts appear too optimistic about the end of the year, even after all the downward EPS revisions. This sanguinity puts the markets at risk of sharp declines on negative surprises.
Money Flows to Lower Risk
An economic downturn, of course, portends lower earnings; but rising interest rates depress stock markets from all directions. While equity markets are pricing in a soft landing, there may be more trouble ahead than meets the eye, and that is not meaningfully priced in.
In recent months, we have been watching the money flowing in droves from bank reserves into Money Market Funds, credit, and government-bond positions, which can now offer a meaningful yield with almost no visible risks. The reserve depletion puts additional stress on banks and will mean less credit and a higher cost of financing for companies going forward.
Besides, with stocks displaying heightened volatility whilst the returns are nowhere near what investors have been used to seeing in recent years, who is to say the same investor outflows will not hit stocks on a larger scale than seen so far this year? In the first quarter of 2023, while stocks were rallying, equity ETFs saw lower inflows than in any quarter since the start of the COVID-19 pandemic. At the same time, fixed-income instruments saw larger-than-average inflows for the fourth quarter in a row. At a time when every economic or market headline jolts stocks, spooking the less risk-loving investors, lower-risk credit or Money Market Funds can easily siphon money from the stock markets. If and when these outflows become meaningful enough, they alone can spark the sell-off.
Stay Invested – Selectively
This uncertainty will keep us company in the near term as investors consider more economic data and changing outlooks for everything from the Fed’s interest rates path to whether the financial system has stabilized or not and apply it to the stock market’s outlook. However, we don’t think divesting from stocks is the right move.
Yes, it might be tempting to try and wait out the storm and return after the skies have cleared. But investors should know that timing the market is impossible; that has been proven so many times that it’s now an axiom. Trying to time the market could be a very costly mistake, as avoiding its down days may mean missing out on the up days as well. About 80% of the best days in the stock markets have happened during bear markets or at the very beginning of a new bull market. Divesting from stocks in bear markets means missing these huge bear-market rallies. Statistically, investors that have missed just 30 of the best days in the last 30 years have seen their cumulative returns cut by over 80%!
So, the recipe is to keep calm and stay invested. However, it doesn’t mean that investors should follow the indexes blindly. Given the state of the economy and the worrying outlook for earnings, it would be prudent to be very selective and choose the best quality stocks whose sound fundamentals and strong market position allow them to come out of the economic downturn relatively unscathed.
We at TipRanks are happy to assist investors in the task of selecting the best stocks. Whether by using our Top Smart Score Stocks tool, Analysts’ Most Recommended Stocks data, subscribing to TipRanks’ Smart Investor Portfolio service, or using one of the Stock Screeners – let us help you navigate through this storm.
