Cyclical Strategy Update I Short Term Resilience Insufficient to Change Base Case I June 2023

Short Term Resilience Insufficient to Change Base Case

Key Points

• Better-than-expected economic data over the past few months does not mean a recession is not around the corner. The market has latched onto more resilient economic data, particularly in the US and has nearly dismissed the idea of a recession this year. We think it will prove costly to for investors to follow this optimism.  1) inflation is still too high and central banks have both the resolve and tools to bring it down with diminishing concern about the economic cost.  2) the rally in US stocks is tactically driven and not supported by fundamentals.  It is very narrowly based and began when sentiment was overly bearish.  3) the resilience in the economic data has come from the waning effect of a depressed base in spending during the pandemic, fading surplus cash accumulation and only modestly tight financial conditions.

• Demand for labour remains too strong and this is the backbone for the resilience to rising rates and in turn, this has been propped up by resilient spending. The labour market has proved a tough nut for central banks to crack, and will only soften when financial conditions tighten more broadly. Until then central banks will keep stretching the policy rubber band.
• A breakdown of US financial conditions shows the only area to have tightened is bank lending, and has not broadened due to limited imbalances in the global economy. In the past, Fed tightening has led to widening credit spreads, rising risk premia, non-bank deleveraging, and tighter bank lending. Less aggressive tightening in financial conditions may be the playbook thus far, but it doesn’t mean financial conditions will not tighten further.  Despite the short-term success of Fed actions in March, the problems in the US regional banks may not be fully resolved.  Recall it was 6 months between the collapse of Bear Stearns and the collapse of Lehmann Brothers during the GFC.
• Earnings growth is key for equity market returns at this stage of the cycle. In the US earnings are tracking as they have just before past recessions. Analysts were too optimistic 12 months ago and the upgrades in the US during the past few months are likely to prove way too optimistic as well. Upward revisions to EPS all occurred in one month (May) following 11 months consecutive months of downgrades.  Downgrades have recommenced in June.