The counterbalance to this economic activity is inflation. Rates of inflation have been coming down worldwide but are still considered too high by most central banks. Therefore, interest rates continue to get pushed higher around the world. Higher interest rates make borrowing more costly, thereby slowing down the real estate market and weighing on corporate activity by increasing the cost of borrowing. Additionally, those higher interest rates provide an alternative to investors weighing trade-offs in risk and return for their capital.
What we are witnessing is an economic tug-of-war, a David vs. Goliath battle, where the brute force of global economic growth tries to overcome the efforts of central banks to tamp down inflation by slowing economic activity with higher interest rates. This struggle raises the question of what caused inflation in the first place and what must be done to quell it now. If the root cause was simply issues with supply chains, availability of workers, or scarcity of energy, that would be one thing. However, if inflation was really driven more by expansionary fiscal and monetary policy, then it may take longer to drain that stimulus from the economy. Central bankers’ efforts to do so are sure to slow economic growth, and the question we all wrestle with is whether it is feasible to bring down inflation without causing a recession.
Questions remain on the overall health of the banking sector, which was marred by the recent failures of Silicon Valley and Signature banks and the subsequent fears that pushed Credit Suisse into the arms of UBS. While the Federal Reserve stepped in with measures to support bank liquidity to meet depositors’ demands, we can still expect that many banks, particularly regional and local banks, are likely to pull back on lending. We will be watching developments in the commercial real estate sector as these regional banks have played a very prominent role in lending to local developers and owners of such properties.
What do market participants make of the possible scenarios from here? The Bulls expect that declining inflation and recent hiccups in the banking sector will permit central banks to end the rate hiking cycle and begin to lower rates sooner rather than later. They are hopeful that inflation continues to ease as the impact of the pandemic on businesses subsides. The Bears anticipate that inflation will take longer to get down to a comfortable level, meaning interest rates will stay high for longer and central banks won’t be inclined to unwind their restrictive monetary policy anytime soon unless something serious breaks.
We believe the preponderance of data indicates we are in the latter stages of this economic cycle: 1) Recent data on layoffs and initial and continuing unemployment claims suggest labor market strength is waning; 2) Market breadth has weakened (limited number of stocks leading the market higher); 3) Money supply (M2) is shrinking; 4) Recent Purchasing Managers Index (PMI) survey data points to slowing orders; 5) Banks are tightening lending standards; and 6) Corporate profits are declining.
Adding it all up, we remain in the cautious camp near term. We continue to believe that the risk of a recession is elevated. We will be convening our Strategy Committee shortly to review our positioning and will review our many tools – Market Cycle Dashboards, Stress Test Scenario Analysis, and forward-looking Capital Market Assumptions – to refine our portfolio recommendations which will follow in our Tactical memo later this month.
Please see PDF for important disclosures.