Bank failures, an AI-led bull market, persistent inflation, Euro area recession, France engulfed in riots, and perhaps the biggest U.S. presidential corruption scandal ever. Looking back on the first half of 2023, it is hard to believe the extraordinary events and outright surprises of recent months.
Some of the possibilities I forecast in January 2023 have come to pass, including persistent inflation and massive shifts in the geopolitical landscape, but other expectations, such as a recession by the second or third quarter, have been delayed, at least in the U.S. if not in Europe. I’m not sure they exist, but I would love to meet any unicorns that accurately predicted the surprises of the first half of 2023.
For example, who foresaw the U.S. experiencing three of the four largest bank failures of all time, with surviving bank stocks down 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 crypto, 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 up 61 percent year-to-date and the tech-heavy NASDAQ up 31 percent, based on newfound hype around the not exactly new idea of artificial intelligence. The broader market S&P 500 eked out 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 is 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 Euro Area, 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 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 7.9 percent in May and EU prices up 5.5 percent in June preliminary numbers.
The central banks have reacted accordingly. While pausing in June, the Federal Reserve has said will 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 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 around $70 per barrel are too low for producers to be happy. Look for a surprise from OPEC+ to be the catalyst. OPEC+ actions 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 will soon have to fill with bond issuance. This will pressure markets, and the banks themselves. The two year Treasury yield is at levels not since before the global financial crisis. The spread to the ten year Treasury is now negative one percent. An inverted yield curve (when short term rates are higher than long term rates) has historically meant recession. At some point the central banks may pivot.
Recession risk has diminished, but remains in play. The Euro Area is now in technical recession with GDP down 0.1 percent in each of the last two quarters. U.S. corporate profits were down 5.1 percent in the first quarter, and were down two percent December. First quarter U.S. GDP was up two 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 six percent, real average weekly earnings were down 1.6 percent through March 2023 and labor productivity was down 2.7 percent in the first quarter.
So while not 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 is not keeping up.
The U.S. consumer may be the biggest risk, as confidence is simply not there. The consumer confidence index is down, with the expectations index below 80 since Nov. 2022, indicating recession. Consumer spending growth has been flat for three months. Personal debt levels are rising, and, with higher interest rates, so too the cost of servicing it. Consumers view the labor market as getting worse and expect inflation to run six to seven percent over the next year.
Geopolitically, the BRICS 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 U.S., 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 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 is not 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 historic highs. Third, don’t get comfortable with lower inflation numbers. Expect inflation to track higher. We’re not out of the inflationary woods by a long shot, and the central banks know it.
An inverted yield curve remains the best predictor of U.S. recession, but with a lag. While Euro Area 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. 2023 will be a historic year, and not in a good way.
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