What’s New

Markets fared well as investors parsed through another month’s worth of data. While a still-resilient economy and sticky inflation data suggested that we may not yet be at the end of the Fed’s hiking cycle, earnings held up relatively well against more modest expectations. Overall, the three major indices all ended the month up, with the S&P 500 noting its second consecutive month of gains.

We saw less market volatility even as the newest GDP report revealed that US economic growth continued to slow in the first quarter – the 1.1% annual rate was down from the 2.6% in the fourth quarter. GDP is a key component when identifying a recession, as a common definition of a recession is two or more consecutive quarters of negative growth. “Is a recession coming?” has been a familiar question since the Fed began their inflation battle in 2022.

Elsewhere, the battle continues as Core PCE (personal consumer expenditures, which excludes food and gas prices, a favorite inflation indicator of the Fed) was hotter-than-expected at 4.6%. With the rate still above the 2% target, many are expecting another rate hike of 25 percentage points at the Fed’s May meeting.

To round out the month’s new data, earnings have not been as bad as expected. Revenue growth continues to hold up, though much of the support continues to come from pricing as opposed to volumes. However, profit margins are falling from peak levels. Interestingly, though, forward looking commentary suggests a lack of excitement about top line growth moving through the year. New data also showed that wage growth remains elevated alongside inflation, supporting another rate hike.

It remains to be seen how long the Fed’s aggressive policy stance for this cycle will continue as the signs of economic stress continue to increase – the first obvious casualty of the Fed being the banking sector. We’d reiterate the familiar remains that monetary policy acts with a lag, and we continue to believe that we are moving through a typical economic and monetary policy cycle.

In fixed income, investors continue to navigate the challenging environment that inflation and the Fed are creating. The 10-year US Treasury yield had its biggest two-month decline since April 2020, finishing the month at 3.45%.

Our Perspective

As we’ve been communicating, our base case remains to be that a recession will be difficult to avoid with the degree of tightening that’s occurred and the work that remains to be done on the inflation front.

Even with our base case, it’s important to not compare this cycle against the prior two recessions as we’re dealing with different circumstances. Instead, we believe we’re going to experience a more “traditional” cycle, which may be longer and more uncomfortable to navigate than what we’ve recently seen. As always, we are viewing this period as an opportunity to be tactical. As the landscape ebbs and flows, we are analyzing all components of monetary policies, economic data, and the evolution of this cycle to prepare our shopping lists to put our time-tested processes to work.

The Economic Impact of Bank Stresses

It’s often said that Fed will “hike until they break something,” but what does that really mean? In March of this year, we saw firsthand what it can look like when the Federal Reserve hikes aggressively enough that something in the financial system ceases to function the way it did before. The implications can be far-reaching, from the capital markets to the real economy. The current hiking cycle has seen this dynamic play out in the US banking system, where we are seeing signs of stress.

Read more: The Economic Impact of Bank Stresses

Our View

• Economic Cycle
• The economy is late cycle; the Fed is being forced by high and persistent inflation to tighten into an already weakening economy; a recession in the US is becoming increasingly likely
• Stock Market
• US stock market weakness has improved valuations, however, equities are not cheap by longer-term historical standards; valuations may be partly explained by robust corporate profitability, as EBIT margins have climbed to historical highs; rising input costs are posing a risk to the ability of corporations to maintain this elevated level of profitability; returns will be harder to come by and stock selection will be increasingly important
• Bond Market
• Interest rates have risen well off their lows reflecting shifting expectations on inflation, growth, and central bank policy; corporate and municipal bond credit spreads have widened, but not enough to make them materially more attractive at this time
• Important Issues on the Radar
• Inflation: a confluence of massive policy stimulus, tight labor markets, gummed-up supply chains, and rising energy costs have caused inflationary forces to broaden and become more entrenched than previously expected
• Ukraine-Russia War: an environment of elevated geopolitical risk entails a general risk-off environment, lending upward support to the dollar, gold, and commodity prices
• China’s Economy: China has pivoted on the two key economic issues that acted as severe headwinds to growth over the last two years; we will now have to see how strong and sustainable the rebound in growth will be

Sources: Wall Street Journal, Bloomberg

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