Market Expects Recession, Wants 3 Rate Cuts

A majority of CEO’s expect a recession starting in the 2nd or 3rd quarter of this year along with 74% of Credit Default Managers and even our own Federal Reserve has a recession this year as their base case. Many Bears adopt a Tom Cruise – Minority Report – attitude needing to fight future crimes of a recession without any evidence. The market wants to declare victory over inflation so that the Fed can start stimulating with rate cuts again. They fear the Fed will keep rates too high for too long and push the economy over a recessionary cliff. Since the astounding $11 trillion in fiscal and monetary stimulus during Covid that created 40-year highs for inflation, the smaller goods side of the economy has since disinflated significantly, as seen below. On the surface this would appear to justify some of the criticism that the Fed is keeping credit too tight until the economy runs into a ditch. 

As the previous chart reveals, the durable goods and raw materials sectors have deflated extensively as consumers have transitioned from ordering couches to watch Netflix and escaped to the brave new post Covid world of travel, restaurants and weddings. The chart below reveals additionally that food and energy were major drivers for this steady 9-month drop in price indices. However, these commodity prices are ephemeral and while energy fell in the first quarter, we are on track to rise again in Q2. The major lagging components are “sticky” related to rent and healthcare and not due to decelerate until the back half of 2023. 

With the Banking scare in March that witnessed the failure of Signature, Silicon Valley and Silvergate banks, there is now a bold consensus expecting one last rate hike on May 3rd followed by an incredulous 3 rate cuts over the ensuing 8 months. While the previous charts would support a need for the Fed to pause now and consider cuts by year end, to price in multiple Fed rate cuts this year would imply an economy about to fall off a cliff. Bears expect sharply rising unemployment (despite over 10 million job vacancies) and a deep earnings contraction far beyond what current stock market multiples are pricing.

However, before retreating to our caves, one should consider that the anger against the Fed for failing to see the signs of falling inflation and the brick wall investors assume we are driving into may be premature or misplaced. The picture of inflation looks quite different when looking at the key inflation indicators that are more reflective of the economy and what the Central bank cares about. In fact, core CPI and the Feds preferred core PCE (Personal Consumption Expenditures) are showing virtually no signs of decline from their 40-year inflation peaks. Additionally, Service Sector inflation (=78% of the economy) remains pegged at its 40-year highs with a forward guidance by travel and leisure companies for strong spending trends over the summer season.  With full employment and stubbornly high inflation, it would be irresponsible for the Fed to pause its rate hiking agenda until there is a trend of rising unemployment and above normal debt defaults or much lower inflation metrics.

Labor demand has certainly plateaued and may soon turn south. However, this chart reveals that the maligned small business sector employers are still in need of workers to meet the large backlog of unfilled orders. Such a “shortage” of workers does not scream rate cuts or a new round of monetary stimulus. There is a long way to fall in small business job openings before a recession or deep recession is on the horizon.

With our expected economic cycle lows approximately one year away, it’s too early for us to presume there will not be a deep recession with high unemployment instead of the minor one that has already been priced in. This is not the future crimes unit of the Minority Report with Tom Cruise blaming Chair Powell for an economic disaster that is nowhere in sight. The Fed needs to witness lower inflation, a growing banking panic or rising unemployment before they think about cutting rates to stave off an unknown potential credit crunch. If indeed multiple rate cuts become warranted this year, then it will be the most over forecasted recession in history. 

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