May 9, 2023
A Fed pause is only bullish for stocks when it occurs in a low inflationary environment. We continue to think that a full Fed pivot is required in order to drive the S&P 500 (SPX) through ~4200. Unfortunately, getting the Fed to pivot likely requires the onset of recession or major crisis in financial markets. Pricing in the bond market points to a likely recession in the next 12 months. Staff at the Fed are looking for a recession, while Powell and the equity market disagree. The bond market is the second largest market in the world behind FX and has a long history of accurately predicting future recessions. Current pricing in the bond market suggests a 67% probability of a recession into year-end, but there’s enough going wrong at the moment to pull the timing forward. The most obvious near-term risk would be technical US debt default. We’d expect US sovereign credit ratings downgrades to occur days before a technical default. A credit rating downgrade alone could be a large enough shock to force an early recession. Regional banking stress and associated collapse in credit creation is another obvious source of economic pain. The strong April jobs print definitely isn’t a recessionary signal, but it could result in rates staying higher for longer. The bond market is currently priced for 65bp of rate cuts into year-end. Pricing those cuts out would cause equity multiple contraction. We expect an eventual Fed pivot, but not without pain first.
Year-to-date equity market breadth has been one of the weakest on record with the most narrow stock leadership in an up-market since the 1990s. It’s not a sign of underlying market health when the largest nine stocks in the S&P 500 are responsible for 80% of the gain.
Consensus is looking for headline CPI to be up +0.4% on a MoM basis, up from +0.1% in March. Depending on rounding of numbers, this would likely result in a YoY rate of +5.1%. The worst case scenario with a ~5% probability would be a headline print above +5.5%. This scenario would result in a ~3% decline in the SPX. We assign a ~25% probability to a +5.3%-5.5% headline number with a brief spike in yields fading into the close due to ongoing regional bank stress and concerns around the debt ceiling. We’d expect little equity market fallout without a strong spike in bond yields. An inline number between 5%-5.2% has a ~50% probability of occurring with no repricing of yields resulting in near-term SPX upside of +0.50%. A headline print in the 4.7%-4.9% range has a ~20% probability. This scenario would result in lower bond yields and an SPX rally of ~1%.