Economic Letter

By Patrick Pascal

April, 2023

U.S. ECONOMY

Economic news suggests that spring has not yet arrived for the global economy. Recent developments in both the domestic and international banking sectors have further unsettled financial markets.

The Congressional Budget Office estimates 2023 real GDP (adjusted for inflation) will grow by just 0.1%, (down from its 2.2% estimate last May) while raising its 2023 projections of inflation to 4.0% from 2.7% estimates at that same time. At the end of March, the New York Fed calculated that the spread between the 3-month and 10-year Treasuries implies a 58% probability of recession in the next 12 months.

The U.S. Department of Labor reported that job gains in March were one-half the level of January and the 12-month average hourly earnings gain of 4.2% lagged behind the rate of inflation. The average work week also edged lower to 34.4 hours compounding household budget pressures.

The Commerce Department reported that households spending rose by a weak 0.2% in February while new orders for manufactured goods fell by a seasonally-adjusted 0.7%. A March survey of purchasing managers by the Institute for Supply Management showed a fifth straight month of contraction in the U.S. manufacturing sector.

INFLATION & INTEREST RATES

While signs of moderation are present, inflation remains high. The Labor Department reported consumer prices climbed 0.4% in the month of February and 0.1% in March. Annual inflation ran at 5% over the prior 12 months. Producer prices also slowed in March bringing the 12-month rate to 2.7%. The European Union’s statistics agency said consumer prices in the eurozone were 6.9% higher for the twelve months ending in March compared to 8.5% rate for the twelve months to February. Europe’s core rate rose to 5.7% from 5.6%. The IMF forecasts global consumer prices will rise 6.5% this year.

Quick and decisive action brought an orderly reorganization of problem banks with little lasting damage evidenced as U.S. bank deposits dropped $363 billion (barely 2%) to $17.3 trillion in reaction. S&P Global calculates that 86% of banks’ securities were federally backed in 2022, versus 71% in 2008. But investors should not be surprised should more such problems arise.

These banking disruptions may limit future rate hikes. Fed Chair Powell suggested a limited banking crisis might have the same effect on inflation as a rate increase, quipping “That means that monetary policy may have less work to do.”

FIXED INCOME

In general, the sharp move to higher interest rates meant shorter duration bonds outperformed longer durations. Tighter lending standards after recent financial instability and higher official policy rates should weigh on growth and dampen long-term inflation, putting downward pressure on nominal interest rates.

As rates rose last year, challenging fixed income markets brought a large dispersion in fixed income returns, creating opportunities for investors. Presently we favor the shorter side of 3-5 year durations with an eye towards lengthening maturities when conditions warrant.

EQUITY MARKETS

After a strong start to the year, equity prices have settled back as economic data have become more mixed. Early market strength was largely propelled by stronger than anticipated Q4 2022 corporate earnings reports and nascent expectations that inflation and interest rates were peaking, and the latter half of 2023 might see less tight monetary policies.

Today, the two most fundamental factors underlying equity valuations are future corporate earnings and interest rates.

Last summer, 2023 aggregate earnings estimates for the S&P 500 Index were around $240-$245. According to FactSet, by December, analysts were calling for a 5% increase in 2023. By the end of March these expectations had dropped to about 1.5%. Most recently, Goldman Sachs cut their earnings estimate for the Index to $195 and further reductions may be warranted.

First-quarter earnings releases and forward earnings guidance (commencing in mid-April) will be particularly important. Most recent downward revisions relate to tighter margins reduced by inflation. After peaking in 2021 (at over 13%) corporate margins are presently around 11% vs the historical average of under 10%.

Rising, or high, inflation also puts downward pressure on price-earnings ratios. Since late 2020, inflation has lowered the S&P 500’s price-earnings ratio from over 38 to about 21 which is very near the average of the past 20 years. Today, valuations are near historical averages. Lower inflation and/or better corporate earnings should result in higher equity prices.

CONCLUSION

Markets continue to face many disparate variables including global inflation, a weak dollar, recession concerns coupled with lower corporate earnings estimates, and banking liquidity issues. Many of these risks are reflected in present equity and fixed-income valuations. We believe that economic and corporate data coming in the weeks ahead, particularly the upcoming first quarter earnings reports and full year guidance, will resolve many of these issues and inform future investment allocations.