A Rally Amid a “Challenging” Backdrop

The U.S. stock market had a pretty strong performance last week with the S&P 500 rallying 6.5% and the beaten down NASDAQ surging 7.5%. This was a bit surprising given that it occurred in the same week that Fed Chair Powell told Congress that achieving a “soft” landing for the U.S. economy would be “very challenging.”

However, we believe there were several reasons that risk assets rallied: 1) bond market volatility has come down from its recent high (see figure 1) with the 10-year U.S. Treasury falling from 3.47% on June 14th to 3.16% currently, 2) West Texas Intermediate oil prices fell from $122 a barrel on June 8th to $108.05 a barrel currently, and 3) long-term inflation expectations have retreated. While these moved are largely reflecting expectations for weaker economic activity ahead, it also means that the Federal Reserve’s attempt to cool the economy by working through expectations may be succeeding. That just might help the U.S. economy to avoid a “hard” landing.

This line chart shows the U.S. Bond Market Volatility (or MOVE) Index from August 2021 to August 2022 year-to-date.

To better understand last week’s rally, let’s look at what happened to the economic data. Last Friday’s 800-point jump (or 2.7%) in the Dow Jones Industrial Average came on the back of a downward revision to the University of Michigan’s 5–10-year inflation expectations index. A couple weeks ago, the long-run inflations expectations index appeared to become de-anchored with an unexpected rise from 3.1% to 3.3% in June. That pop unnerved both financial markets and the Federal Reserve as they seemingly believed that it was a sign that inflation was become more embedded in the economy and consumer’s expectations were reflecting that. In response, the Fed apparently leaked the prospect of a 75-basis-point rate hike to the press and then followed through with it at their June Federal Open Market Committee (FOMC) meeting. Well, last Friday, the University of Michigan revised that data and the index fell back to 3.1% - about the same level it has been at for all of 2022 (see figure 2). That helped the market to take a deep breathe.

This line chart shows the University of Michigan’s 5-10 Year Inflation Expectations in percent from 1995 to 2020 year-to-date.

Breakeven inflation rates also suggest that the Fed’s attempt to bring down expectations through its hawkish guidance may be working. The 5-year breakeven inflation rate, which is the bond market’s version of the University of Michigan’s index, has come down from 3.73% on March 25th to 2.85% on June 27th. Still above the Fed’s long-run inflation target of 2.0%, but nearly a full percentage point lower. In theory, a steady decline in long-run inflation expectations should increase the odds that the Fed will have more policy flexibility in late 2022 or early 2023.  That can be seen in the fed funds future implied rate with the market pricing in a 77% chance that the Fed’s target rate will top out below 375-400 basis points by June 2023 (see figure 3). This seemingly implies very few rate hikes in 2023. Though we should note that our Citi Research colleagues are maintaining their view that a target rate of 4.0% remains the most likely outcome.

Investor sentiment may have also been boosted by an unexpected 10.7% pop in new home sales in May, but we would caution against that as we believe that the housing market will be slowing materially in the year ahead as the surge in mortgage rates drags down the demand for housing. Though we do not expect the cooling off to be anywhere near that which occurred during the Global Financial Crisis as housing assets as a percentage of household net worth is significantly lower than during that period.

This bar chart shows the Target Rate Probabilities for the June 14, 2023 FOMC Meeting. Data indicates that probability for the 250-275 target rate in basis-points is 0.2%, 275-300 is 2.4%, 300-325 is 12.2%, 325-350 is 29.4%, 350-375 is 32.8%, 375-400 is 17.9%, 400-425 is 4.6%, and 425-450 is 0.5%.

Is the U.S. Economy in a Recession?

With first quarter 2022 U.S. real gross domestic product (GDP) coming in at an annualized rate of minus 1.5% and the Atlanta Fed’s GDP now tracker suggesting 0% growth in the second quarter of 2022 a few weeks ago, some have been inclined to say that the U.S. is already in a recession. It is possible as the National Bureau of Economic Research (or NBER), which is the determining body of U.S. recessions, often labels U.S. recessions well after they have begun, but we doubt it.

The actual definition of a recession as defined by the NBER is not two consecutive quarters of negative growth. It is “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” While the Atlanta Fed’s GDP Now forecast is tracking at just 0.3% currently, much of the weakness is concentrated in the potential change in private inventories, which are expected to drag down 2Q 2022 growth by about 1.42%. Personal consumption expenditures (also known as consumer spending) is expected to add 1.81% to growth. We think that is the more important component to watch as the swing in inventories is reflecting an anomaly due to supply chain issues and not typical economic drivers. We would be much more concerned if consumer spending were to drag down growth by 1.42% as that would be more indicative of a widespread downturn in economic activity as consumer spending accounts for nearly 70% of real GDP. Swings in consumer spending are much more important than swings in inventories. We would also note that rising goods inventories should lead to falling goods prices as retailers slash prices. That could eventually be a powerful tailwind given the Fed’s extreme focus on inflation metrics.

Likewise, leading economic indicators remain consistent with an expanding economy with the indictor still positive on a year-on-year basis (typically it falls below zero percent several months prior to a recession). Right now, it is in the 3% range, which is consistent with about 2.0% real GDP growth year-on-year (see figure 4). This is in line with Citi Research’s U.S. economics team’s forecast of an annualized growth rate of 1.7% in the second quarter of 2022.

This line chart shows the U.S. Leading Economic Indicators Index vs. Real GDP from 1986 to 2021 year-to-date.

However, that does not mean a U.S. recession will be avoided. Particularly if inflation does not start to trend downward and the Federal Reserve remains on its current path well into 2023. If that were to occur (we put the odds of a recession at about 40%), then we may see another leg down in U.S. stocks. Though historical patterns continue to suggest that the majority of this sell-off may be behind us (see figures 5-6).

Also, let’s not forget that bear markets are often followed by bull markets with bear market recoveries often lengthy and substantial. Since 1932, the S&P 500 averaged about a 102% rise from the market trough over an average length of 686 trading days. This time around, the recovery may take some time with the lag between monetary policy and its impact on the U.S. economy often taking about 12-18 months to occur, but it is often the case that the stock market bottoms well before the economy does. This bear market may be yet another example of that. Overall, for investors with high levels of cash, we are becoming increasingly confident that dollar-cost averaging into the stock market over the next four quarters may be a positive endeavor.

What Should U.S. Investors Watch in the Week Ahead?

Thursday’s release of the personal consumption expenditure (PCE) deflator will probably be the event of the week. Headline PCE inflation, the Fed’s preferred measure of inflation, is expected to climb from 6.3% to 6.4% while core inflation is expected to fall from 4.9% to 4.8%.

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