May 2023 Market Update

Since our April market update, the banking crisis has worsened. Following the failures of Signature Bank and Silicon Valley Bank in mid-March, First Republic Bank failed on May 1st. As stated in our April Market Update, https://www.macrovex.com/post/april-2023-market-update “stockholders will not be saved. Bank equities can fail, as assets across the economy adjust to new valuations resulting from higher interest rates, there will likely be more problems arising in banking and real estate that leads to a contraction in credit. A credit contraction would likely reduce demand and send the U.S. economy into recession.”

For the month of April, the ISM Manufacturing Index reading came in at 47.1, up from the March reading of 46.3, yet still in its sixth consecutive month of contraction. The Chicago PMI reading came in at 48.6, up from the March reading of 43.8, and the Consumer Price Index, CPi reading for the month of April, came in at 4.9% year over year. Down from the high of 9.1% in June of 2022. Core CPi remains sticky, with the data reading coming in at 5.5%, this remains the Federal Reserve’s focus.

We believe that while core inflation remains sticky at 5.50%, the Federal Reserve is likely finished with rate hikes for this cycle. The Federal Funds Rate of 5.00%-5.25% is now above the year-over-year CPi reading of 4.9%. Historically, raising interest rates above the year over year CPi level has effectively brought inflation down and induced a recession in the U.S. economy in order to restore price stability.

The message we receive from the Fed is a hawkish pause. Meaning the Fed is done raising interest rates, but if inflation rises month to month and core inflation remains sticky, above 5.5%, then they could decide to raise interest rates again. However, we see this as unlikely, as the manufacturing sector has already entered recession.

This message should help the market do the Feds job for them. As rate cuts are left off the table with the message of a hawkish pause, this should help reduce inflation expectations by keeping nominal interest rates anchored to the Feds hawkish guidance while communicating to the market that rate cuts are not to be expected. As rate cuts get priced out, inflation expectations, earnings estimates and company guidance are likely to begin to decline at a faster pace. This means breakeven inflation rates decline faster than nominal interest rates and real interest rates rise at the onset of deflation. When real interest rates rise, asset valuations decline.

The 10-year minus 2-year yield spread is still negative -49 basis points. Which means banks are uncomfortable and not lending to one another. In 2008, re steepening of the yield curve was a necessity before assets in the economy could be marked to market and those assets could receive a viable bid. We believe the banks and the economy are in a similar situation. As such, we believe the markets need the yield curve to steepen so that banks lend to each other, so the market can have a recession with liquidity. Until then it is unlikely an asset manager will mark assets to market, because in this environment there would likely be no stable bids for the assets. We expect the Federal Reserve’s messaging of a hawkish pause to cause the yield curve to re steepen as the labor market continues to deteriorate. We continue to keep a close watch on continuing claims and permanent job losses as they rise.

The federal funds rate is now at its highest level since 2006. Savers are receiving the highest risk-free interest rate on their cash in seventeen years. The opportunity cost for taking risk is high. There will likely be an event or catalyst that will shock the system. It could be any number of things. But when it happens, the valuation readjustment will be fast. Manage your risk and prepare your portfolio to endure a recession.

With the S&P 500 trading around 4150, at approximately 20x earnings, we continue to believe investors will be rewarded by being positioned risk off and in cash, short term interest rates, 0–5-year U.S. Treasury bills and notes, money market funds, 10-year minus 2-year yield curve re steepening and select low duration equities.