The founder of investing newsletter site BullAndBearProfits.com and former investment banker at JPMorgan and Merrill Lynch said in a note on Monday that the US economy is still headed for a downturn. The latest evidence of this, he said, is a resurgence in inflation.
While the consumer price index hit 3.1% year-over-year in January, down from 3.4% in December, Wolfenbarger is more focused on so-called supercore inflation, which is services inflation minus shelter. The measure spiked significantly in January.
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Supercore inflation is the Federal Reserve’s preferred measure of inflation, as it takes out the volatile food and energy components, as well as housing costs, and allows the Fed to focus on the cost of labor.
This concerns Wolfenbarger — who has been calling for a recession since late 2021 — because inflation rising again means the Fed will likely have to keep rates higher for longer, which has historically been a drag on the economy and stocks.
Options market odds have already begun to reflect this change. In December, investors were pricing in rate cuts as early as March 2024. The odds of that happening are now just 2.5%, according to the CME’s FedWatch Tool. Investors are placing the highest odds on a cut in June. Some say the Fed’s next move could even be a hike if inflation flares up enough — former Treasury Secretary Larry Summers said earlier this month that he places a 15% chance on that outcome.
In addition to the prospect of another inflation flare up, the usual recession indicators are still flashing red, Wolfenbarger said. They include the inverted Treasury yield curve and The Conference Board Leading Economic Index, which have perfect track records in preceding recessions over the last several decades.
But a more under-the-radar recession indicator has also recently produced a positive signal, he said. That’s the amount of tax revenue the IRS collects on a year-over-year basis, which is now down -10.5%.
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“Since it is illegal to fudge income for tax purposes, declining Federal tax receipts is about as definitive a sign of declining incomes as is available,” Wolfenbarger said. “As this chart shows, Federal tax receipts are now down 10.5%. Historically, declines of this magnitude have only been seen during major recessions.”
‘Ominous’ signs for stocks
While the macro picture shows signs of deterioration, a couple of technical indicators also show potential trouble ahead for stocks, Wolfenbarger said.
The first is that market breadth is poor, as shown by the Dow Jones Industrial Average’s outperformance of its transportation index (a cyclical sector) and the Value Line Geometric Index, which tracks the market’s median stock.
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Second, the S&P 500 continues to rally despite a surge in the CBOE Volatility Index (VIX), a development that Wolfenbarger called “ominous.” This happened during the last two major market declines, though it’s unclear how sustained of a trend the move is.
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Wolfenbarger said a decline to new bear market lows is likely. While stocks have been in a new bull market last year, the most recent bear market lows were seen in October 2022, when the S&P 500 hit 3,583. That represents 29.6% downside from current levels.
A gap between investor sentiment and reality?
Talk that inflation could rebound picked up in the days following the January inflation report, which marked the eighth consecutive month that CPI failed to dip under 3% toward the Fed’s long-term goal of 2%.
Cole Smead, the co-manager of the Smead Value Fund, which has beaten 98% of similar funds since 2014, told Business Insider on Wednesday that he sees inflation averaging 5% annualized through the 2020s as fiscal spending remains high, boosting the need for the government to borrow, therefore propping up interest rates and hurting high-valuation stocks.
Earlier this week, JPMorgan strategist Marko Kolanovic made similar points in a client note and warned that things could go sour soon. He said that despite the prospect of rate cuts being pushed out until the second half of 2024 thanks to higher inflation, investors have not yet priced in the risk that comes along with higher rates for longer.
“We believe Investors should be open-minded that there is a scenario in which rates need to stay higher for longer, and the Fed may need to tighten financial conditions. The ~25% stock market rally since October was predicated on a repricing of the Fed (from cutting only 2 times in 2024, to cutting ~7 times in January). While most of those incremental cuts are now priced out, the stock market did not correct at all,” Kolanovic said in a client note. “Volatility has been unusually low, and risk positioning has increased substantially over the past year.”
Kolanovic also pointed out that positioning in stocks is historically high. The market cap of stocks versus the amount of cash in money market funds is in the 80th percentile, he said, and the percentage of household assets that are held in stocks is “near record highs.”
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Still, it remains to be seen whether inflation meaningfully picks up again. If price growth remains subdued and the labor market continues to show its intrepidness, stocks could be in for another good year. But if the economy overheats again, hawkishness at the Fed could return, perhaps setting up investors for a rude awakening.
