In the wake of April’s U.S. retail sales report, the attention of the market was drawn not to the modest 0.4% increase, but rather to the significance of a rebound after four consecutive months of decline. While economists expected a rise of 0.8%, traders found optimism in the fact that sales didn’t plummet as they had in the preceding months. Additional data released on the same day revealed a 0.5% growth in industrial production during April, surpassing expectations, and a fifth consecutive month of increased builder confidence amid the ongoing shortage of homes available for sale.

Buoyed by these positive indicators, yields on various government debts experienced an uptick. This increase was fueled by the possibility that inflation pressures still have room to expand. As a result, traders adjusted their predictions for a potential interest rate hike by the Federal Reserve in June, with the likelihood rising to as much as 30% before settling around 23%. The market became abuzz with discussions among economists, analysts, and traders, contemplating a non-basecase scenario where the economy proves more resilient and recession-resistant than anticipated.

Lawrence Gillum, Chief Fixed Income Strategist at LPL Financial, noted that despite interest rates exceeding 5%, the economy has not displayed the usual signs of vulnerability. Default rates for corporations have remained stable, and consumer delinquencies are below long-term averages, indicating that businesses and households can meet their financial obligations. Gillum also highlighted the sustained demand for workers, indicating a 25%-30% chance of an economy that simply “muddles through.” However, LPL Financial still projects a 60%-65% likelihood of a recession in the latter half of this year.

Recession concerns resurfaced when U.S. Treasury Secretary Janet Yellen warned that a default on government debt could trigger an economic downturn. Despite this, Federal Reserve Bank of Atlanta President Raphael Bostic confirmed that interest rate cuts are not expected until at least 2023, even in the event of a recession. Nevertheless, fed funds futures traders continued to factor in potential rate cuts.

The most notable game-changer from the Covid-19 pandemic has been inflation, which has defied expectations, disrupted low-interest-rate trends, and rattled financial markets. Despite the consumer price index showing an annual headline rate below 5% for the first time in two years, inflation remains persistent. The Federal Reserve’s rate hikes since March 2022 have done little to curb this trend.

Interestingly, the pandemic might have inadvertently strengthened the U.S. economy, creating an environment of “survival of the strongest” where resilient companies thrive. Economist Derek Tang from Monetary Policy Analytics suggests that as businesses and households fortify themselves against extreme outcomes, inflation and consumption don’t decrease as anticipated. The housing sector is one example of unexpected strength, as homeowners holding onto their properties due to previously low interest rates limit the supply available to new buyers, thereby keeping prices elevated.

Tang explains that while recession indicators may flash, they are based on historical patterns, and it is possible to witness a manufacturing recession without a general economic downturn. A “muddling-through” scenario could favor stocks if the strongest companies gain greater market share. However, it would also introduce volatility to the rates markets as the Fed navigates a choppy path toward higher rates.

According to Gillum, resilient economic conditions can support equity markets as long as inflation subsides quickly, signaling the Federal Reserve’s successful intervention. Conversely, a less favorable outcome marked by stagflation, where inflation persists and more rate hikes loom, would dampen market performance.

As the pandemic continues to shape the economic landscape, unexpected shifts and outcomes challenge conventional wisdom and highlight the need for a flexible approach to market analysis and prediction.

By: Malou Benjamin