For the past few months, investors have had to weigh the Federal Reserve’s continued effort to bring down inflation by raising interest rates and the potential for those actions to push us into a recession versus a surprisingly resilient economy. Current economic data has generally exceeded expectations, as measured by the Citi Economic Surprise Index, signaling a still-growing economy. This has helped support stocks. Meanwhile, inflation has remained stubborn, and the Fed has signaled continued interest rate hikes. The ebbs and flows of inflation and the economy have caused stocks to ping-pong within a fairly tight range for months.
Early March saw the failure of two large regional banks, a brief panic on the part of some depositors, and swift action by the Federal Reserve. Evidence suggests any further banking problems are company specific, not systemic. However, we do think the fallout from this will weaken the economy. Bank lending standards have been tightening for some time; that is likely to accelerate in the coming months and should have the effect of weighing on the economy and growth. On the other hand, it may result in the Federal Reserve being more accommodative going forward.
What would cause the market to break out of its recent range? Signs of an imminent recession, such as a spike in the unemployment rate, are a potential catalyst for a break to the downside. The combination of signs of rapidly falling inflation, a corresponding Fed pause, and continued strength in the economy could cause the market to break out to the upside. We often look to internal measures of market health to provide clues about the market’s next move. After strengthening rapidly in January and holding up well during February’s decline, several key measures of market health deteriorated as the banking crisis unfolded. While the price levels of market indices have recovered losses since then, many of the key indicators that we monitor have not. The message of the market is mixed, at best.
On the positive side, the Fed is likely close to finishing its rate hiking cycle. Investor pessimism remains extremely high. Credit spreads, usually a good forward-looking indicator, are consistent with a still-growing economy and low expected default rates. Overall, we remain in a market where patience and discipline remain crucial. Taking a strong stance either way is inappropriate; we will do so only when the weight of the evidence suggests it is correct to do so.
