The key is to figure out what regime we're in The key is to figure out what regime we're in\images\insights\article\hockey-faceoff-small.jpg May 12 2023 May 12 2023

The key is to figure out what regime we're in

That could determine if above- or below-average historical returns are likely.

Published May 12 2023

This week took me to sunny Traverse City, where I met with a great group of bankers along serene Lake Michigan. With 90 minutes to speak, I covered my near-, intermediate- and long-term economic and market views. The group’s questions weren’t so much about our year-end target but what happens after. Stepping back, in which regime will we find ourselves? The 1992-2021 period that saw low, stable and predictable inflation and a stunning 30-year period of 12.9% annualized real returns on the S&P 500, or the stop-start inflation era of 1966-1992, a 26-year period of real returns averaging a much lower 4.3%, with the first 14 years at -0.7%. Deutsche Bank shares that in the past 20 months without a core CPI print below 0.2% m/m, the annualized real return on the S&P was -9.6%. The point, it emphasized, is that while equities can clearly go up a lot over time, there can be long-lasting eras of above-average and below-average returns. Inflation is a key factor in these outcomes, which is why the standoff between a hawkish Fed and inflation prints that have moderated but remain somewhat hot (more below) matters so much. Consider that since 1950, the S&P has traded roughly at a 15x P/E with headline inflation readings between 4-6%. Today it’s trading at a roughly 20x P/E with a headline inflation reading of 4.9%. If it were to trade in-line with historical multiples and Strategas Research earnings estimates, the S&P would be at 3,000! Gulp!

The economy keeps surprising, in part because Americans aren’t all that rate sensitive. Many consumers and corporations locked in rates at or near their recent historic lows and are in no hurry to expose themselves if they don’t have to. Just ask frustrated would-be homebuyers facing slim pickings because boomers won’t sell. Moreover, the economic pain that is occurring is hitting upper-echelon households (where the bulk of $1 trillion+ of excess savings resides)—"homes receiving jobless benefits” is accelerating the fastest and after-tax wages are falling the fastest in the $125k+ income cohort. Lower-income households with the highest propensity to consume are getting jobs and raises. The economy has weakened but it’s debatable if it’s worsening. Half of Bank of America’s global growth indicators are sending bearish signals but the breadth of the deterioration has stabilized since September. In the U.S., Philly Fed coincident indexes improved in 49 out of the 50 states the past three months. While bank lending has softened and seems likely to pull back further amid stresses that look to stick around, Bank of America finds it noteworthy the slowdown is concentrated in C&I and CRE loans, particularly at smaller banks. Overall commercial loan growth remains positive, and loans to consumers are rising at or near double digits. Piper Sandler is skeptical. It views loan growth as a lagging indicator and thinks tightening standards are more indicative of what’s to come. It agrees with consensus on a recession by year-end or early 2024.

So, which regime are we in? Since 1971, there have been 124 instances in which the fed funds target rate was lowered, and only six of those cuts occurred with an unemployment rate under 4% and only 21 with a rate under 5%. The jobless rate was 3.4% in April. The market is pricing in 75 basis points of cuts by year-end, which would suggest there needs to be a material weakening in the labor market. Hard to see it without a nasty turn down in the economy, an outcome recent data doesn’t support. Hard to see the Fed caving, too. The yield curve is forecasting almost a 70% chance of a recession in the next year, while odds priced into the equity market still look to be at most 50-50. If the economy continues to expand, Empirical Research sees earnings growing 3-5% this year (blended earnings growth in Q1 could finish around -1%, far above expectations). If there’s a recession, it thinks earnings could fall a relatively mild 15%. The standoff between the Fed and the labor market, where demographics (i.e., the exodus of boomers) are keeping the situation very tight, is key. So, too, is getting a handle on fiscal largesse and an exploding deficit (more below). Outside of small caps, equities have rallied significantly off October lows, with the S&P up 16%, albeit led by a handful of mega-cap names. It keeps encountering technical resistance at 4,200, with macro uncertainties swirling. Where next? Depends on which regime we’re in, and the jury’s still out.


  • Cause for a pause CPI rose in line with expectations in April on higher energy and goods costs, and moderated y/y at both the headline and core levels, with softness in underlying components. The shelter step-down looks durable (market rents have been flat for five months), inflation’s breadth is narrowing and recent strength in used-car prices looks temporary. PPI for April came in slightly below consensus, and y/y export and import prices contracted sharply.
  • Why all the worry about housing? Buyers may be frustrated by the dearth of existing homes on the market (existing owners don’t want to give up low-rate mortgages), but new home sales are at a 1-year high and new home sales sold but not yet started are at a 13-month high. Publicly traded home builders continue to report growth, and mortgage purchase loan applications have risen seven of the past 10 weeks. Worries about falling home prices appear overdone, too, as the 1-year-ahead median expected home price change has risen to its highest level in almost a year.
  • What’s the opposite of, “The devil’s in the details”? While the NFIB Small Business Optimism slipped again in April to a fresh 10-year low, the underlying details were much more encouraging. The net percentage planning to increase employment rose, matching February’s level, and current job openings climbed to their high for the year. Also, the net percentage expecting credit conditions to ease managed to tick up despite the recent banking stress, with firms reporting a somewhat wider availability of loans compared to three months ago.


  • Bond vigilantes mounting up U.S. debt servicing costs have exploded to their highest level since August 1999. Historically, once these costs hit 14% of tax revenues, financial markets impose austerity on policymakers. That metric surged a full percentage point in April to 12.7% amid a complacency in Washington that rising debt is a political issue, not an economic or financial one. With U.S. government debt as a percentage of GDP the second highest in the G10, the main long-term risk for the dollar arguably is this complacency, though it likely will play out over decades, not years.
  • It typically takes a recession to break embedded inflation expectations In the latest New York Fed Survey of Consumer Expectations, the median 3-year-ahead expected inflation rate climbed to its highest level of this year and the median 5-year-ahead expected rate rose to its highest in almost a year. Today’s Michigan sentiment reading showed inflation expectations five years out at 3.2%, its highest level since 2011.
  • Don’t count on China The reopening of the world’s second-largest country from its strict Covid-zero lockdown continues to disappoint as a broad-based recovery is still struggling to take hold. China’s April imports surprisingly fell 7.9% y/y, decelerating from March’s 1.4% decline on subdued domestic demand, and exports slowed to 8.5% y/y from 14.8% in March, with the manufacturing PMI still in contraction.

What else

What’s the opposite of, “The third time’s a charm”? Arguably, Biden’s two biggest blunders to date relate to avoiding what Dems believe were major mistakes of the Obama years: 2009’s too-small crisis-relief stimulus package (resulting in Biden’s $1.9 trillion bonanza that fed inflation) and the failure to get out of Afghanistan (leading to Biden’s hasty and poorly executed withdrawal). Now comes a potential third: 2011’s collapse of a $4 trillion “grand bargain” between Obama and House speaker Boehner (driving Biden’s refusal to negotiate over the debt ceiling, a stance markets fear will lead to default).  

A pause is better than a cut At least, that’s what Credit Suisse research shows. It found that, historically, stocks perform quite robustly in the 12 months following the last hike of a cycle but are flat-to-down when the Fed cuts rates, in part because a lower rate tends to signal that the economy is faltering.

Just chocolate for Mother’s Day, thank you Bank of America shares that Americans now spend more money on legal cannabis than chocolate.

Connect with Linda on LinkedIn

Tags Equity . Markets/Economy . Inflation .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Consumer Price Index (CPI): A measure of inflation at the retail level.

G10, or Group of Ten: A group of actually 11 industrialized countries, including the United States and much of Europe, with overlapping economic interests.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.

Producer Price Index (PPI): A measure of inflation at the wholesale level.

Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Small company stocks may be less liquid and subject to greater price volatility than large capitalization stocks.

Stocks are subject to risks and fluctuate in value.

The Federal Reserve Bank of Philadelphia produces a monthly coincident index that gauges economic activity in all 50 states.

The University of Michigan Consumer Sentiment Index is a measure of consumer confidence based on a monthly telephone survey by the University of Michigan that gathers information on consumer expectations regarding the overall economy.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

Federated Equity Management Company of Pennsylvania