Ever since we saw the U.S. economy slip at the beginning of last year, the calls for an eventual recession have mounted and are more numerous than Tesla price cuts. Continued tightening by monetary authorities through 2022 and into 2023 was supposed to generate a broad contraction in economic activity. Unemployment was supposed to be climbing, leading to weak consumer spending, declines in factory output and lower inflation. While there have been areas of weakness identified in recent months, it has not been widespread and, in this week’s conference call, I briefly touched on this. Developments this month, however, suggest that the cracks in the U.S. and Canadian economies are widening.

 

On the call, I reviewed an indicator that we have covered many times in our blog and that is the Citi Economic Surprise Index. For review, this index measures the degree to which economic indicators for a given country have come in either above or below economist forecasts. A positive value means that, collectively, results are ahead of estimates and vice versa.

 

 

 

The above chart shows the surprise index for the U.S. going back to the beginning of 2022. Things looked pretty healthy in the first few months of the year (despite the hindsight knowledge that real gross domestic product, or GDP fell in the first quarter). Following the Russian invasion of Ukraine and the start of rate hikes by the Federal Reserve in March, indicators began to come in below projections. The surprise index went from a peak above 60 in April to a low of minus 80 in June. Note, this accurately reflected the fact that real GDP fell again in the second quarter.

 

The index recovered through most of the second half, reflecting both an improvement in the economy and marking down of economist estimates of where things stood. Things started to fall apart again towards the end of the fourth quarter (right after stocks bottomed out in October) and we saw a slump through into January. This coincided with an increase in calls for a recession in the first half. But then something strange happened. The economy wasn’t crumbling but showed resilience across many segments. The surprise index rose to around plus 60 by the end of March, yet this again had a lot to do with economists marking down their estimates of activity (setting the bar lower).

 

 

 

April has seen a distinct pullback in the surprise index for the U.S. and a continued retreat in the index for Canada, which you can see in the above chart. In fact, Canada’s index did not see the weakness in December and January as witnessed in the U.S., but it has been sliding in recent months. The index itself is not yet back into negative territory but is getting close. The one caveat with the Canadian surprise index is that many of our reports here lag behind those in the U.S. For example, we have only just seen reports on February manufacturing, wholesale trade, building permits and final retail sales. Still, the pattern for both countries is clear. Things are cooling and not a moment too soon, lest stock markets get it all wrong again.

 

There is certainly an interesting aggregate behaviour. I don’t know if I would label it complacency per se, but maybe just a thickening of the skin. The financial crisis stunned most investors and then they were hit with the aftershocks of Greece, the euro crisis, tariff wars and finally a global pandemic. In each instance, things turned. Unfortunately, these events also started to reinforce the view that governments and central banks would always bail us out. Consider the banking correction (I refuse to call it a real crisis) in the U.S. only several weeks ago. It rattled equity investors so much that the resulting flight to quality drove the 2-year US treasury note yield from north of 5% to around 3.75% in less than three weeks. Anxiety levels cooled down in fairly short order, yields bottomed out and started to rise again, and stocks seemed to find yet another higher bottom.

 

 

 

The above chart shows the S&P500 on an intraday (high-low-close) basis going back to the start of 2022. I often reflect on this chart, as well as the one that shows the aggregate bond index, as they both show losses of close to 20% - something we avoided by more than half. A key observation is the level of volatility through last year was high as stock valuations fell. Recently though, the gyrations have been less, as equities have climbed back. Indeed, the S&P has traded in a very tight range since the start of the year. This is another way of saying that volatility has gone down. Way down.

 

The Chicago Board Volatility Index (VIX) rose briefly above 25 in March amidst all the U.S. regional banking concerns – more than ten points below where we got in October, and we saw those levels a number of times throughout 2022. Today, the VIX is trading around 17 and that is the lowest since, you guessed it, the end of 2021. In fact, since the pandemic the VIX has never declined much below 15. Prior to the pandemic, it had traded below 10 but I think we all agree that was also a calm before the storm. The question now is whether this diminished volatility is again a precursor to another shock to markets, or just a little splash of reality?

 

 

 

Coming back to the economic data, Ally and I do believe a downward trend in activity is continuing and becoming more broad-based. In a couple of weeks, we will get April employment figures for Canada and the U.S., and they should show moderation. Now, the Fed will meet just before the report and decide on where to put its official overnight rate target. Consensus is for another quarter-point hike, but the key focus will be on the language. If Fed officials are seeing the same signs we are, then there could be language in the text that speaks to a pause. Note, I’m only talking pause at this juncture. We are months, if not quarters from reaching a state where the Fed or the Bank of Canada needs to lower rates.

 

That duration of leaving rates at elevated levels is what should continue to eat away at the economy. That doesn’t mean we get a sudden and sharp contraction, but a widening of the cracks. Stocks will have to account for this, and, in my opinion, we are going to see volatility push higher and stock valuations will decline. If you think back to the S&P chart, a return to the floor of the recent trading range (around 3800) would represent a 10% correction. If we head back to October, that is a 15% correction. To get a bear market, which means a 20% decline, we are talking of a return to late November levels. In order to come close to the financial crisis, the S&P would basically have to retreat back to the lows of March 2020 when we shut the global economy down because of the pandemic.

 

I would place very low probabilities on a 2020 return, as this would require some massive shocks (continued rate hikes into the second half or another bout of geopolitical tension). That said, we are going to see tightening in financial conditions as some banks in the US tighten lending standards alongside continued high rates. I do think investors should at least be prepared for a re-visit of the October lows and have the appropriate amount of defense built into their portfolio. That includes many of the themes we have been following for months – increasing dividend yield, moving to larger cap stocks that have sound balance sheets, rotating into those sectors that have underperformed (energy and financials) and lowering the overall risk of the bond portfolio and staying tactical. The slowdown that is unfolding is tardy indeed, but it will be more important to see if it’s steeper or shallower than what the market expects.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.