In an episode of “The West Wing” (Season 5), an aide to Chief-of-Staff Josh Lyman starts to reassure his boss: “If the economy is headed into recession …” “No, no, no,” Lyman interjects. “We don’t ever use that word around the White House.” They settle on a euphemism instead: bagel. “So, if it is a bagel … the Fed thinks it’s gonna be a mild bagel,” says the aide.

The sketch aired in 2004, on the upswing off the mild recession that had followed the dot-com bubble. Mostly after the fact are media inclined to speak freely of economic contractions and the obfuscation that surrounds their early days. At the peak of economic activity, a devil’s pact exists to extend and pretend. The rhetoric must play along. As the Fed reported last month that a “mild recession” is likely after the banking failures this spring, they’re probably talking about bagels in the White House.[1]

Most others also aren’t uttering the notorious word. Joseph Brusuelas, economist with accounting giant RSM, says the r-word to describe the economy “should be resilient, not recession.” Any residual political fallout from the slowing of economic growth over the last 12 months has been blunted by the recent resiliency of the stock market.

The market is frequently wrong, however. It’s a voting machine in the short run and a weighing machine in the long run, said Benjamin Graham. We at MCM invest bottoms-up based on historical valuation patterns and have, consequently, argued that the market has widely mispriced equities. An optimist might point to its current strength as a measure of investor consensus. Looking past the headlines, though, the market tends to betray its weakness.

A Tale of Two Markets

There’s a hole in the middle of the market’s strength, and it is wide. The shares of materials producers were flat for April. Consumer discretionary, industrials, regional banks, transport, and small caps were all significantly lower. This belies the positive gain on an index-wide basis. In fact, fully 90% of the S&P 500 advance this year has been on the backs of seven companies—Apple, Microsoft, Alphabet, Amazon, Tesla, Meta, and Nvidia. The old cast is having an encore. These companies led the bounce off the 2022 low, but the environment has changed.

Only Meta and Tesla had year-over-year (YOY) gains in topline growth. As the money supply has contracted over the year, so have the revenues of stock market leaders. Most are still great businesses, but having reached maturity, it’s improbable they can grow at their previous rates. The bounce from the 2022 lows should not be unexpected. Neither is it likely to be a harbinger of a sustainable trend. The rest of the index speaks to the narrow breadth and deteriorating fundamentals underlying the current rally.

The weakness in small-cap, temporary-staffing companies is an illustrative example. Despite a chorus of angst over rising wages and a labor shortage, most investors predict the firms that supply that labor to underperform.

Figure 1: Manpower, Top; Trueblue, Bottom

Shelley Simpson, president of J.B. Hunt Transport Services, recently went so far as to describe the drop in transport volumes as a “freight recession.” Remember the seagoing traffic jam of goods crushing the port of L.A. during the pandemic? Volumes are down there 35% YOY in March. Shoppers are recovering from their binge in the purchase of consumer goods. So far in 2023 shipments of recreational vehicles—the poster child of discretionary luxury expenditures—are less than half of what they were this time last year. While entertainment has been a beneficiary of the reopening, there too sales volumes are contracting. Hotels, restaurants, air travel, and the like are not seeing the tech rally follow through to their income statements.

One Metric to Rule Them All

Historically, the most reliable metric for the arrival of a bagel is the yield curve. Economist David Rosenberg highlights the “Three D’s” of inversion: depth, dispersion, and duration. Most analysts look to the spread between the 10-year and 2-year Treasury yields (which is colloquially known as the 2s10s). When the 10 minus the 2 is negative, recession is typically on the way. The metric first crossed zero on April 4, 2022.

Figure 2: 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity

The inversion has been deep and long. An even more reliable metric is the inversion of the 10-year and the 3-month. It followed suit in October of 2022. To avoid these inconvenient historical correlations, the Fed announced in March 2022 that it prefers a different inversion metric—the 3-month Treasury bill yield minus the 18-month forward rate on the 3-month Treasury bill yield (which is not known colloquially as anything because the Fed just made it up).[2] In addition to the Fed’s logic being as hollow as a bagel, this metric also inverted some months later. Conspicuously, no one has asked the chairman about this occurrence in subsequent press conferences. Seemingly, the pressure to toe the rhetorical line is highly effective.

Perversely, it could be the unspoken acknowledgment that recession is on the horizon, if not already upon us, that has fueled the stock market’s resiliency. Investors have been conditioned, now for decades, to expect the Fed to come to the rescue of markets from economic malaise. If business conditions are deteriorating, then the Fed will be forced to cut rates. Forward prices on U.S. Treasuries demonstrate that rate cuts this year are now consensus.

As equity investors have become habituated to intervention by the central bank on account of any market turbulence, they likely read market probabilities of rate cuts as an indication that the Fed will triage any weakness in their portfolios. Such investors might be sadly mistaken. The Fed routinely attempts to be proactive. Unfortunately, its powers of perception are limited, as is characteristic of human finitude. The unintended consequences of the Fed’s attempts at economic management are manifest in the recent banking crisis. This is a contemporary example of “The Pretense of Knowledge” about which we wrote in our Q1 letter a month ago.

As we put the final touches on this post, Friday morning, May 5, 2023, the regional bank stock crisis continues unabated. The shares of PacWest Bancorp and Western Alliance Bancorp, pictured below, are the latest dominoes to fall. While relatively smaller than Silicon Valley Bank, these new episodes demonstrate the systemic stresses caused by the Fed’s efforts to tame inflation. Not surprisingly, the swap market is now pricing in the first Fed funds rate cut for July, and perhaps as early as June 2023.

Figure 3: PacWest Corp, Top; Western Alliance, Bottom

The central bank is most effective in times of crisis when it runs a playbook of liquidity first and asks questions later, and this usually only after considerable pain for investors. Therefore, if the central bank again rides to the rescue of equity indexes, it will be post-facto. Further, while inflation appears to be moderating, the pieces are in place for a protracted struggle against higher-than-trend cost pressures. Such worries could stay the Fed’s hand in the short term, causing it to fret less about the plight of equity investors. If either is the case, stock markets would have even more to worry about than bagels.



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