For example, who foresaw the United States experiencing three of the four largest bank failures of all time, with surviving bank stocks down by 25 percent for the year? Who knew that the banking sector would prove so fragile, remaining standing only because of unprecedented access to emergency government lending facilities?
Who would have guessed that cryptocurrency, specifically Bitcoin and Ether, which combined represent about 70 percent of the crypto market, would have been the best-performing asset class—up year to date 84 percent and 55 percent, respectively—in the face of an all-out assault on the industry and its entrepreneurs from the Biden administration and its enforcement arm at the Securities and Exchange Commission?
Or that tech would make a roaring comeback, with the FAANGs—Facebook (Meta), Apple, Amazon, Netflix, Google (Alphabet)—up by 61 percent year to date and the tech-heavy Nasdaq up by 31 percent, based on newfound hype around the not exactly new idea of artificial intelligence. Even the benchmark S&P 500 Index rose a relatively modest but still impressive 16 percent.
The stock market rebound in the face of not-so-great underlying economic realities appears to be a collective form of willful blindness. The tune of market participants: “Keep dancing as long as the music plays on.”
The equity markets are disregarding the implications of persistent inflation, a severe banking crisis, a debt-ceiling non-deal that kicked the can down the road and did nothing to address the underlying problem of runaway government spending and $22 trillion of cumulative deficits, a confirmed recession in the eurozone, and what appears to be one of the largest presidential corruption scandals to ever afflict the United States.
While headline inflation numbers have come off their peaks, core inflation remains persistent and too high for comfort. June’s core Personal Consumption Expenditures Price Index, the Federal Reserve’s so-called favorite metric, just came in at 4.6 percent, signaling a long road ahead for the Fed’s inflation fighting. Inflation is worse in Europe, with UK prices up by 7.9 percent in May and European Union prices up by 5.5 percent in June preliminary numbers.
The central banks have reacted accordingly. While pausing in June, the Federal Reserve has said that it'll likely continue to raise rates above the current 5.25 percent target. At the same time, the Bank of England just raised rates to 5 percent and the European Central Bank raised rates to 4.25 percent.
My expectation is that inflation will continue downward through the summer, but then start to rise again in the fall. This shift could be driven by energy prices or monetary policy.
Oil prices of about $70 per barrel are too low for producers to be happy. Look for a surprise from OPEC+ to be the catalyst. Actions taken by OPEC+ could tighten the market so much that prices will rise toward the end of the year to above $80 per barrel or even $90 or $100. China’s economy must get moving for this to be true, but the government is taking aggressive stimulatory action.
The second driver could be a return to quantitative easing, even if labeled something else. The government needs to fund its deficits, and the debt-ceiling non-deal will basically allow the printing presses to run until 2025. The U.S. Treasury has a $1 trillion hole that it'll soon have to fill with bond issuance. This will pressure markets and the banks themselves. The two-year Treasury yield is at levels not seen since before the global financial crisis of 2008–09. The spread to the 10-year Treasury is now negative 1 percent. An inverted yield curve (when short-term rates are higher than long-term rates) historically has meant recession. At some point, the central banks may pivot.
Recession risk has diminished but remains in play. The eurozone is now in a technical recession, with gross domestic product (GDP) down by 0.1 percent in each of the last two quarters. U.S. corporate profits were down by 5.1 percent in the first quarter and were down by 2 percent in December 2022. First-quarter U.S. GDP was up by 2 percent on stronger-than-expected exports but down from the fourth quarter’s 2.6 percent. Both are well below historical norms. Even though nominal wage growth is now above 6 percent, real average weekly earnings were down 1.6 percent through March, and labor productivity was down by 2.7 percent in the first quarter.
So while it isn’t technically a U.S. recession, weakness remains. Corporate profit margins are high by historical measures, but falling from peaks. While cost inflation is pressuring margins, companies are passing on much of it to the consumer, and taking some back from employees as compensation isn’t keeping up.
The U.S. consumer may be the biggest risk, as confidence simply isn’t there. The Consumer Confidence Index is down, with the expectations index below 80 since November 2022, indicating a recession. Consumer spending growth has been flat for three months. Personal debt levels are rising and, with higher interest rates, so too is the cost of servicing it. Consumers view the labor market as getting worse and expect inflation to run 6 to 7 percent over the next year.
Geopolitically, the BRIC countries (Brazil, Russia, India, China, and South Africa) continue to realign in an anti-American and anti-West coalition. This will be negative for the U.S. economy and for the U.S. dollar over the long run. France, Europe’s second-largest economy, is failing to contain destructive riots occurring throughout the country. In the United States, the UPS Teamsters, the largest single employer union in the country with approximately 340,000 members, is on the verge of a nationwide strike. Both have the potential to grind their economies to a halt.
So what are the key takeaways in light of all this? First, the year’s extraordinary equity market performance is unlikely to persist through the end of the year. Second, the banking crisis isn’t over. Hedge funds are betting against the banking sector, and banks’ utilization of emergency funding lines from the Fed and Federal Home Loan Banks remain at historical highs. Third, don’t get comfortable with lower inflation numbers. Expect inflation to track higher. We aren’t out of the inflationary woods by a long shot, and the central banks know it.
An inverted yield curve remains the best predictor of a U.S. recession, but with a lag. While the eurozone recession is already here, this by itself won’t drag down the U.S. economy, although a massive strike could. U.S. consumer weakness remains the threat. Most of the commentary from consumer-facing public companies is negative.
In summary, don’t get lulled to sleep by the not-terrible GDP print and markets data. This is a long operatic drama we’re watching, and the fat lady has yet to sing. The year 2023 may well be a historic year—but not in a good way.
