Markets Were Calm in April, but Recession Fears Still Linger
After a volatile March, April was a refreshingly quiet one for the financial markets. No more regional banks failed, and the Federal Reserve had no meetings. Therefore, investors could, and did, remain focused on positive economic data. Corporate earnings beat expectations and the inflation rate continued to fall. As a result, U.S. stocks, as measured by the S&P 500, finished the month up by about 1.6%.* Will all this calmness and cautious optimism continue, and if so, for how long?
The answer depends on several factors, but first, let’s take a closer look at April. While the labor market remained strong, the better-than-expected corporate earnings numbers for the first quarter were due largely to recent downgrades in estimates.** Meanwhile, inflation numbers released in April by the Bureau of Labor Statistics showed prices climbing 5% year-over-year for March, which was down from 6% in February. For the month the increase was just 0.1%, which marked the ninth straight month of easing price growth.*** Extrapolating these figures forward means we’re already pretty close to the Fed’s target inflation rate of 2%, although not quite there yet.
All of this made investors confident the Fed would stick to their plan to raise short-term rates by no more than another quarter percent at their early May meeting. The Fed not only stuck to that plan, but they also signaled they would probably pause rate hiking altogether at their next meeting in June. Why? Well, despite the positive data, there are still concerns among investors and economists that conditions are right for a recession later this year.
Inverted Yield Curve
Remember, one of the classic warning signs of a recession is an inverted yield curve, which occurs when short-term interest rates are higher than long-term rates. Until recently, the bond market was accommodating the Fed’s rate hiking program, and long-term rates had risen ahead of each of the Fed’s rate increases. Last year, long-term rates were pushed to their highest level in 16 years. But for most of this year, the bond market has been pushing back against the Fed. Although the Fed’s benchmark short-term rate is now roughly 5.1%, the interest rate on the 10-year government bond has fallen from 4.06% in early March to 3.43% as of early May.****
In other words, the Fed knows they can’t continue inverting the yield curve further, which makes a rate hike pause in June very likely. At the same time, however, they want to continue talking tough about inflation and are reluctant to proclaim “mission accomplished” and announce the end of rate-hiking altogether. Still, they’ll have little choice in the matter if the economy tips into recession. It’s likely they would even have to start lowering rates again to fight the recession, which, of course, they now have plenty of ammunition to do.
All of this is why I continue to believe that if a recession does hit, it will be a mild one that doesn’t last long. As I’ve said before, you can think of it like a controlled burn conducted by the fire department. A recession is always a danger when the Fed is raising rates, but because the Fed causes it, they also have some control over it — which isn’t necessarily the case when a recession is caused by a major economic crisis.
The Lag Period
So, when will we know the answer to the recession question? Probably sometime in the coming months once the lag period between all the Fed’s rate hikes and their full impact on the economy is over. It always takes time for the effects of higher borrowing costs to ripple through the economy. Once that happens, will it slow things down enough to start a recession? If so, we could see the markets sink further before the Fed starts lowering rates again, which would likely trigger a market rebound. If, on the other hand, it appears the Fed has managed to bring down inflation without triggering a recession and is finally finished raising rates, then we could see the markets get back to a more normal, less volatile pattern and potentially reach new highs.
In the meantime, you can continue taking comfort in knowing your interest and dividend return will remain consistent no matter what happens. You will see this again reflected in your latest monthly statement, and most of you will also see that your account values were also slightly higher for the month. Of course, as I frequently point out, while a rebound in values is always nice to see, it’s also largely irrelevant when you’re investing for income — just as any drop in value is also irrelevant because it doesn’t affect your income return.
Keep this in mind going forward because these fluctuations are likely to continue, perhaps for the rest of the year, based on all the factors I just discussed. The good news is that with the Fed likely at or near the end of its rate hiking, the worst is probably over in terms of bond market headwinds, and we could even start enjoying some consistent tailwinds in the near future.
*“US Equities market Attributes, April 2023,” spglobal.com, May 2, 2023
**Nasdaq.com, May 2, 2023
***“Inflation Cooled to 5% in Marcy but Consumer Pain is Set to Linger,” CNBC, April 12, 2023 ****MarketWatch.com
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