The signs of an imminent recession are growing, yet the stock market rose sharply after the Silicon Valley Bank failure. It is difficult to point to a concrete reason, but the stock market is perhaps anticipating massive interest rate cuts as things get worse. After Bear Stearns failed in March 2008, stocks rallied ~15% before resuming their downtrend.

• Bond markets continued to rise following the failure of 3 major banks in March. Stock performance was mixed. Seven stocks now account for most of the positive market performance in 2023: Apple, Microsoft, Amazon, Google, Facebook, Nvidia and Tesla.

• Economic data continues to be poor. While recent GDP growth is muted at 1%, core inflation is holding strong as the service economy muddles along. This is classic "stagflation": inflation with little growth.

• Our view is that stock market in about to finish the current bear market rally. The Fed is still raising rates, core inflation is high, employment is strong and bad news is coming out slowly. On Friday, First Republic Bank was shut down by the FDIC. The bank failures are symptomatic of stress in the financial system that will eventually affect the broad economy.

Table 1: Market performance estimate as of 4/28/2023 (LIMW)

Performance discussion

During April, all major markets rose except for small caps and emerging market stocks. Energy stocks performed well despite the decline in oil prices and technology stocks rose following good earnings reports.

Bond markets rose sharply after the shutdown of Silicon Valley Bank. There is a massive movement of cash underway from the banking system to the bond and money markets. This will create ongoing problems for the economy because this type of depositor outflow sucks cash out of the banking system, preventing bank lending. We expect this to negatively affect mortgage, auto, and business lending, significantly impeding economic growth.

Figure 1: Heat Map of S&P 500 Stock Performance 2023 Year-to-Date (Finviz.com). Box size represents weighting within the S&P 500 Index.

Figure 2: Recent fall in yields indicates a massive movement of cash into the bond market (LIWM). Remember, for bonds it's yield down = price up.

Economy continues to gradually slow down

The purchasing manager surveys (PMIs) provide us monthly readings on the economy. One of the reasons they are timely data points is that the survey participants are not submitting any materially non-public information and the survey is only a few weeks old. From a compliance perspective, this gives us insight into economic activity months before it is officially reported by the government or companies during quarterly earnings calls.

The manufacturing PMIs currently indicate contraction, but not severe recession. The service PMIs indicate moderate growth. These readings are from early March and we will be getting fresh numbers this week for April that should be very interesting. There are reports of a massive decline in bank lending mid-month April. Notice the deceleration from July 2021. The economy has been normalizing to slower growth for a while now.

One of the reasons inflation has been so persistent despite Fed rate hikes is that the United States is a service economy. Sectors such as health care, consumer staples, government, education, and utilities are usually not severely impacted by higher interest rates. Inflation is easily passed on to consumers in the service economy.

Figure 3: Institute for Supply Management (ISM) and S&P Global Purchasing Manager Surveys indicate slowing (LIWM)

Good news and bad news on inflation

As the economy decelerated, we expected inflation to fall. With regards to headline or total consumer price inflation (CPI) that is exactly what we see. Headline CPI peaked in 2022 at 9% and fall to about 5% in the latest reading. That is the good news.

The bad news is that Core inflation remains stubbornly high. Core inflation excludes commodities like food and energy to give policy makers at the Federal Reserve a sense for the underlying long-term trend in inflation. Their favorite Core inflation reading looks at the inflation of personal consumption and is called Core Personal Consumption Expenditures (Core PCE). This is important because the Fed will be making policy decisions based on this data point and it is not falling like the other inflation readings.

How does this relate to the current situation? If the stock market is strong because it is anticipating rapid interest rate cuts, the Core PCE inflation readings indicate this may be an incorrect assumption and the Fed may hold rates higher for longer as they have promised.

Figure 4: Headline consumer price inflation (CPI) continues to fall

Figure 5: Core Personal Consumption Expenditures (Core PCE) inflation remains stubbornly high (LIWM)

Bank lending started slowing last year

Bank lending is the lifeblood of the economy. Whether it be housing, manufacturing, or education, almost every significant consumer purchase involves a bank's willingness to lend. That makes changes in bank lending behavior very important.

Surveys of bank lending officer intentions provide helpful insights into future lending activity. The Federal Reserve collects this data from their member banks to see if they are easing or tightening their lending standards.

The Fed collects this data to see if their policies are working. Today, the Fed's policy is to slow lending, slow economic growth and hopefully slow inflation. In the surveys, we can see that lending intentions have been tightening since last year. Do you see how this behavioral change contributed to past recessions and recoveries?

Figure 6: Senior Loan Officer Survey of lending intentions 1990-2023 (LIWM)

The labor market is starting to weaken

One of the key factors we watch is the labor market. Currently, the labor market has been very strong despite Fed rate hikes and other signs of economic weakness. A strong labor market means wages are high and that contributes to strong core inflation.

There are some signs that the labor market is starting to weaken. In the weekly Initial Jobless Claims, we can see that unemployment claims are starting to rise. You have to ignore the pandemic spike in the data and compare today's change with the gradual rises we saw in the 2000 and 2008 recessions. It is our view that the labor market is weakening and this may be one of the last signs that we are entering a recession.

Figure 7: Initial Claims for Unemployment 1998-2023 (LIWM)

Our bear market indicator says the current bear market isn't over

There are hundreds of economic data points analysts follow to make predictions about the markets. Most of them are interesting, but not predictive. Several years ago, a Wall Street firm filtered hundreds of indicators to determine which ones were leading indicators. In other words, which ones anticipated large movements in the stock indexes.

We combined the 5 most efficacious leading factors into one indicator to give us a Probability of Bear Market Indicator. Here are the factors:

1. 10-year/2-year Treasury yield spread. This captures periods when the Fed is raising rates significantly. Currently max bearish.
2. ISM PMI Manufacturing index. This indicator tells us if the cyclical part of the economy is contracting and in recession. Currently max bullish.
3. Inflation. When inflation is high, the Fed raises rates to slow down the economy and subsequent inflation. Currently max bearish.
4. Valuation. The Shiller Price/Earnings ratio measures current market values against a 10-year moving average of earnings. Bear markets are frequently preceeded by overvaluation. Currently moderately bearish.
5. Unemployment. Low unemployment indicates a strong economy and perhaps higher interest rates. High unemployment indicates a weak economy with weak earnings. Currently max bearish.

Today, the indicator is past its cyclical peak, but nowhere near a trough. It tells us we are still in a bear market and the bottom is still ahead of us. If the current bank failures morph into a financial crisis, we may see readings as low as 2009.

Figure 8: The LIWM Bear Market Indicator 2000-2023 (LIWM)

The rumors of the Dollar's demise are greatly exaggerated

I shamelessly paraphrased Mark Twain, but I couldn't resist.

There are several research reports out suggesting that the world is abandoning the US Dollar and that this might lead to a collapse in our currency. While possible, I think the probability of this occurring is very, very low.

First, to push the US Dollar off of its pedestal, something else must replace it. Gold? There is limited supply and it's difficult to carry around. Bitcoin? The largest bitcoin banks that tie bitcoin accounts to the US bank systems have failed (FTX and Signature Bank).

Perhaps the Euro, Yen or Yuan? Our trading partners do not want to be the reserve currency because it directly opposes their mercantilist policies. Mercantilists want a cheap currency to facilitate trade and build a trade surplus. Only we Americans have been willing to make the sacrifice of a strong Dollar and trade deficit. The new reserve currency country must be willing to let their currency strengthen, let their industries be poached, and be prepared to enforce their rules with a competent military.

The Chinese may be preparing to confront us militarily, but their entire economy is based on global free trade protected and encouraged by the US Navy. Who can they sell to if their ships can't transit the globe? Chinese Yuan is not convertible to other currencies; if you bank in China, getting your money out is difficult. Not one European country has an effective military. Japan similarly has been pacifist since WWII. None of the other world powers have the ability or willingness to be the global reserve currency.

Second, with all the pandemic stimulus spending winding down, government spending as a percent of GDP is returning to normal levels. Our national debt however, is an enormous $31 trillion and is at a record high relative to our GDP. China, Japan, and Europe all have worse metrics in this area, however.

The inflation problem in the United States is a permanent reduction in the spending power of our dollars, but all our trade partners are pursuing inflationary policies worse than ours that will hurt their currencies. The Federal Reserve is raising interest rates and the economy is slowing. This should lower inflation in time. This all implies a strong US Dollar compared to other currencies.

Someday this may change, but in our view that change is far into the future.

Figure 9: Currency strength comparison 2007-2023 (LIWM)

Figure 10: Total government spending as a percentage of US GDP (f=federal, s=state, l=local) (www.usgovernmentspending.com)

Figure 11: US Federal Deficits as a percentage of GDP 1970-2023 (www.usgovernmentspending.com)

Current market commentary

Equities remain in a bear market that began in January 2022. It is our view that the bear market will continue until four key factors are aligned:

1. Inflation falls - Headline CPI fell 9% to 5%; Core CPI still strong 4.5%.
2. Employment falls. Labor market is currently strong.
3. Earnings fall. 2023 EPS estimates are down about 12% from 2022 peaks.
4. Interest rates fall. The Fed is planning to raise interest rates next week.

So far, we have only seen modest weakness in inflation and earnings from the peak in 2022. Employment and interest rates are still rising.

Strong rallies can happen during bear markets. We think we are in one right now. If the current rash of bank failures causes the Fed to begin cutting rates, we will reassess this conclusion.

How many banks need to fail to trigger a Fed response? Historically, not many. In the five years prior to 2008, only 10 banks failed. The first Fed rate cut happened in September 2007, but by then it was too late. During 2008, 25 banks failed including Bear Stearns, Indy Mac, Lehman Brothers, and Washington Mutual. More banks were lost in the following years: 140 banks in 2009, 157 banks in 2010, and 92 banks in 2011.

It appears that in this cycle so far, the Fed is not panicking over the lost of 4 large banks. They are much more focused on their inflation problem.

In our view, it is still too early to declare a bottom. The bullish analysts are fighting the Fed and the Fed is fighting inflation. We expect stocks and economic growth to get worse before getting better. This view is exactly why we are bullish on bonds.

Figure 6: Current equity market situation (LIWM)

Final Thoughts

We are in the midst of a difficult bear market in stocks and bonds. The Fed is still raising rates, inflation is high but decelerating, earnings are weakening, and employment remains strong. We expect the Fed to continue raising rates to 5.0 - 5.25% in May, which will result in problems for the stock market and economy. Conversely, this should be positive for the investment grade bond market if inflation falls as the economy slows.

We remain underweight equities and overweight bonds. The current bear market rally is getting old and the Fed is unlikely to back off their tightening policy in coming months.

If you are concerned about your situation and would like to speak with us, please reach out to us at the phone numbers below.

We look forward to hearing from you!

Rob 281-402-8284

Chris 281-547-7542

Robert Lloyd, CFA^®

President and Chief Investment Officer

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-402-8284

[email protected]

www.lloydsintrepid.com

Christopher Lloyd, CFP ^®

Vice President and Senior Wealth Planner

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-547-7542

[email protected]

www.lloydsintrepid.com

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