On the one hand...

Bottom Line 

Strong labor market drives spending The U.S. labor market remains relatively healthy, with an unemployment rate at a 53-year low of 3.4%. That’s critical because people who have jobs usually keep spending. Given enormous pent-up demand and a modest deceleration in both mortgage rates and home prices over the past several months, the housing market has strengthened. Auto sales have risen nearly 20% since December, and retail sales (possibly because Easter arrived late this year) were positive month-over-month in April for the first time since January. 

Macroeconomic outlook mixed But consumer confidence has weakened across the board, due to persistent inflation, rising interest rates, growing recession fears and tighter lending standards. Last month, the NFIB small business optimism index plunged to a 10-year low and inflation expectations embedded in the Michigan Consumer Sentiment survey soared to a 12-year high in May. 

Manufacturing weak Manufacturing data has weakened considerably over the past several quarters. The ISM manufacturing index has fallen below the critical 50 level in each of the past six months, a reliable recession signal over the past 75 years. Except for Chicago, the five regional Fed manufacturing indexes we monitor have been negative over much of the past year and are plumbing 3-year lows.  

Rocky landing or recession? The Leading Economic Indicators (LEI) Index has declined 13 months in a row, an occurrence consistent with recession over the past seven cycles. With a 2/10 yield-curve inversion at 57 basis points, the bond market is still pointing to an elevated risk of a rocky landing or recession at some point over the next year or so. 

Higher for longer Inflation peaked last year and is receding, but at a deliberate pace. Nominal CPI inflation eased from 5% year-over-year (y/y) in March 2023 to 4.9% in April, and core CPI slipped from 5.6% to 5.5%. Federal Reserve officials don’t think inflation will approach their 2% inflation target until year-end 2025 at the earliest. That was a major factor in their decision to raise the fed funds rate for the tenth consecutive time in the last policy-setting meeting, a quarter-point hike on May 3. As the benchmark rate now sits at 5.25% and nominal CPI grew 4.9% y/y in April, they may have successfully orchestrated the appropriate inflection point to launch their long-awaited “pause” at their June meeting. Unlike the consensus, however, we believe they may choose to sit on the sidelines until 2024. 

Better-than-expected reporting season We’re nearly 95% of the way through the first quarter 2023 reporting season for the S&P 500. Revenues, earnings and profit margins were not particularly good, but they were better than depressed expectations. Revenues rose 4.1% y/y, below the level of inflation but better than consensus estimates for a modest 1.8% increase and down from a strong 13.9% increase in the first quarter of 2022. This marks the weakest revenue growth rate since a -1.1% decline in the third quarter of 2020. Earnings declined -2.5%, but that’s better than the consensus expected decline of -6.8%. By comparison, earnings rose a solid 10.3% y/y in the first quarter of 2022. This represents the largest earnings drop since the -31.8% decline in the second quarter of 2020, during the pandemic. Profit margins declined -7.6% y/y, the fifth consecutive negative quarter, but that’s better than the consensus expectation for an -8.5%. If first-quarter GDP growth of 1.1% represents the high-water mark of 2023—with negative prints in the second half of 2023—revenues and earnings may slow further. 

Wild cards abound Although we do not believe that the recent banking-industry tremors are reminiscent of Bear Stearns and Lehman Brothers during the 2007-09 global financial crisis, tighter lending standards and lower loan volumes could slow the economy. Moreover, as the debt ceiling drama grinds on in Washington, we’re hoping to avoid a repeat of the equity market’s 20% air pocket during the third quarter of 2011 when the market faced the same issue.  

Are equity investors overly bullish? Despite our litany of concerns, the S&P has rallied nearly 21% since last October’s intraday low to Friday’s overbought cycle high at 4,213;  benchmark 10-year Treasury yields have soared to an oversold 3.72%. 

Tweaking our estimates The equity, fixed-income and liquidity investment professionals who comprise the Federated Hermes macroeconomic policy committee met last Wednesday to discuss the mixed economic picture:

• The Commerce Dept. flashed its first quarter 2023 GDP growth rate figure at a weaker-than-expected gain of 1.1%. That compares with third- and fourth-quarter growth of 2.6% and 3.2%, respectively. The economy is clearly decelerating. 
• The Fed hiked rates by another quarter point on May 3, marking what could be their terminal rate at 5.25%. Despite this, the labor market remains healthy, and consumer spending, housing and auto sales were solid in April. So we raised our second quarter 2023 growth estimate from a gain of 0.2% to 0.5%. The Blue-Chip consensus raised its from a loss of -0.1% to a gain of 0.4% (within a range of -1.1% to 1.7%).
• Noting the sluggish pace of “Mapril” spending (the 2-month period that is a strong indicator of the direction of the economy), we’re concerned about the important Back-to-School season. But with offsetting rebounds in housing and autos, we took our third quarter 2023 forecast from -0.6% to -0.5%. The Blue-Chip consensus lowered its from -0.3% to -0.6% (within a range of -2.3% to 1%).
• With knock-on concerns about slower Christmas spending, we lowered our fourth quarter 2023 estimate from -0.7% to -0.8%. The Blue-Chip consensus tweaked its down from 0.2% to 0.1% (within a range of -1.7% to 1.8%).
• We left unchanged our full-year 2023 GDP growth rate projection of 1.1%. The Blue-Chip consensus lowered its from 1.2% to 1.1% (within a range of 0.7% to 1.6%).
• We left our year-end 2023 forecast for core CPI inflation unchanged at 3.9%, down from a 40-year high of 6.6% in September 2022. We also did not adjust our year-end 2023 forecast for core PCE inflation from 3.5%, down from a 39-year high of 5.4% in February 2022.
• We left our full-year 2024 GDP estimate unchanged at 1.1%. The Blue-Chip consensus reduced its estimate from 0.9% to 0.7% (within a range of 0.0% to 1.6%).
• We increased our year-end 2024 forecast for core CPI inflation from 2.8% to 2.9%, but did not adjust  our estimate for core PCE inflation from 2.5%. 

Connect with Phil on LinkedIn