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Market Commentary: May 2023 – An Exercise in Frustration

An Exercise in Frustration

May 2023

By Jonathan McAdams, CFA

My oldest son is a cross country and track athlete, and I tell people that apple fell very far from my genetic tree. My coaches used to tell me that I ran like a sewing machine – a lot of up and down, but I didn’t go anywhere. That analogy also describes the stock market of late – there have been a lot of ups and downs, but it has gone absolutely nowhere for a full year now.

Not that there hasn’t been plenty of excitement – it’s been a bumpy ride. We’ve had a tech crash, record inflation, record corporate earnings, the most aggressive Fed in 40 years, and now, a banking crisis with parallels to 2008. This push and pull of good and bad news has kept the market in a sideways pattern instead of on an upward trajectory.

Let’s look at these data crosscurrents in a little more detail. On the positive side, corporate earnings have proven much more resilient than investors had expected given pressure on margins from heightened inflation. Quarterly earnings peaked last year and have shown negative growth the past two quarters, but the 3% year over year decline this quarter is a far cry from the 15% – 30% declines seen in prior weak or recessionary earnings episodes. At the end of the past quarter, the majority of companies – 79% – reported earnings above expectations. This is higher than both the 5- and 10-year average, and for the first time in recent memory, analysts are revising their forward estimates up rather than down.

This brings us to the second positive: resilient corporate earnings and a historically tight labor market. It’s hard to have a weak economy when almost everyone has jobs. Yes, we’ve seen the headlines from tech firms about large layoffs, but this is more a result of a hangover from COVID-bubble over-exuberance than it is a reaction to a weak economy. In fact, initial unemployment claims across the country are still at record low levels, and we haven’t seen any of the spikes that typically signal the start of a recession.


However, unemployment is only one data point, and the picture does not look so rosy when looking at a broader collection of recessionary indicators. One of these is the Conference Board’s Index of Leading Economic Indicators, a collection of 10 data points that have historically been predictive of oncoming recessions. This index, below, has turned negative 6-12 months before virtually every recession (the grey vertical bars in the chart) of the past few decades, and it is strongly negative now.

The second major negative component relates to spillover effects from the Fed’s aggressive pace of rate hikes over the past year – currently manifesting most aggressively in the banking crisis. We have written on this topic several times, but suffice it to say that the recent failure of three of the largest banks in history is having a chilling effect throughout the financial system and broader economy. Banks are tightening lending standards and preserving capital while also having to raise their funding costs via deposit rates, which hurts profitability. We may not have seen the worst yet, as low interest rate commercial real estate loans from past years will begin to mature and reprice at higher rates. A healthy banking system is critical to the flow of capital and economic activity.

Banking stress has, at least, taken some of the burden off the Fed’s rate-hiking campaign. In fact, the markets expect the most recent rate hike to be its last for the foreseeable future, as the banks are doing the tightening instead. Stocks, particularly large growth stocks, have rallied this year on this idea of the Fed being done raising rates. However, bond markets are now predicting that the Fed will have to lower rates in the second half of the year. If this happens, the catalyst would likely be either the economy plunging into recession or the banking crisis worsening – neither of which are favorable for markets.

Much of this market uncertainty circles back to what we have been talking about for some time – inflation. Inflation has cooled of late, giving the Fed breathing room to “pause” their rate hikes as mentioned. If inflation does not continue to come down, then the Fed will be in a very difficult spot, forced to choose between keeping rates elevated to fight inflation or dropping them to respond to a softer economy or financial distress. This is what the market continues to grapple with and why we can’t seem to make any progress – strong employment and corporate earnings on one side, and high inflation, rate hikes, and recession fears on the other. Like a runner, sometimes the market races to its destination – and sometimes, like me, it meanders at a plodding pace. But even if it takes a stumble over the next few months, we know it always gets back up and finishes the race.

Shannon Dermody

Shannon DermodyTEST

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