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  • A 3-month to 10-year Treasury yield inversion can precede a recession.
  • Rate increases are slowing manufacturing and consumer spending, cooling inflation.
  • GDP growth and low unemployment keep hopes for a shallow recession alive.

When the 3-month Treasury bill yields more than the 10-year Treasury note, it’s historically been a harbinger of recession. Typically, yields increase alongside maturity to compensate bond buyers for the risks of tying up their money for longer. However, when economic speedbumps emerge, that relationship can turn upside down. When it does, it can signal that the economy will tailspin.

Currently, the spread between the 3-month and 10-year yields is -1.28%, the most upside-down reading since the early 1980s when Paul Volcker was hiking 1970s-era inflation into oblivion.

As you can see in the following chart, a 10-year/3-month yield curve inversion like we're experiencing often precedes a recession (grey bars). Given the relationship between inversions and recession, it’s unsurprising that key economic data has been lackluster recently.

CHART-Street-Smarts-JS 011923

A weakening economy

The Fed’s engaged in a war with inflation, increasing rates dramatically to slow the economy, reducing demand. Inflation has been stubborn, but evidence the central bank’s policy is working is mounting.

Commodity prices, such as crude oil, have declined since summer, and gasoline prices turned negative year-over-year last month. Falling input prices have reduced headline Consumer Price Index inflation from 9.1% in June to 6.5% in December. The Fed’s favored inflation gauge, Personal Consumption Expenditures excluding volatile food and energy, has also improved from 5.4% in February to 4.7% in November. We’ll get December’s PCE reading on January 27th.

Decelerating inflation suggests a weaker economy, something retail sales data and industrial production numbers confirmed this week.

Action Alerts PLUS’ Chris Versace writes: 

"On a month-over-month basis, retail sales fell 1.1%, more than the expected 0.8% and the 0.6% dip in November. Tying this together with layoff announcements and the continued climb in consumer credit, we continue to see shoppers being far more choosey with their spending…Pure retail rose 5.2% year over year in December, clearly being impacted by higher prices when compared to the December Consumer Price Index print of +6.5% year over year.”

The year-over-year retail sales figure trailed inflation, suggesting consumers bought less last month. That's problematic for inventory levels and shipping demand and bad news for manufacturing. 

December industrial production fell 0.7%, its second consecutive monthly drop. Versace writes that's "a sign manufacturers are pulling back in response to softening demand for goods.” Overall, manufacturing output declined 1.3% in December, falling an annualized 2.5% in Q4.

A soft landing?

One big argument among economists is whether a recession will be shallow or deep. The goldilocks scenario is a “soft landing” of slowing GDP and inflation alongside less severe increases in unemployment.

So far, that’s still a possibility. U.S. Gross Domestic Product was negative in the first and second quarters of 2022. However, it rebounded 3.2% in the third quarter, and currently, estimates are for 3.5% growth in the fourth quarter, according to the Atlanta Fed’s GDPNow forecast.

Also, job losses haven’t been too bad. Initial jobless claims improved to 190,000 last week, down from 205,000 the previous week. The four-week moving average improved to 206,000 from 212,500 the week before. December's unemployment rate remained impressive at 3.5%, suggesting resiliency.

A recession will likely increase layoffs, but wage gains add credence to the soft landing argument if unemployment remains historically low. However, one worrisome sign worth tracking is that the average hourly workweek has fallen -- a possible precursor to firings.

The Smart Play

Individual stocks bottom before the market, and the market bottoms before the economy. As a result, investors should be cautious about extrapolating poor economic data to stock performance.

Fourth-quarter earnings reports will offer insight into demand, inventory levels, and cost-cutting plans. How stocks react will be telling. If poor results prompt buying, it would strengthen the argument that current prices reflect weakness. If not, then more pain could be ahead.

Historically, a solid start to the year and widespread buying over ten days (breakaway momentum), as we’ve recently seen, has preceded full-year positive returns for the S&P 500. However, returns don’t happen in a straight line, and recent strength means stocks became short-term overbought.

Active investors can continue buying the low and selling the high end of Doug Kass’ expected 3700 to 4100 range on the S&P 500. The S&P 500 was flirting with the high end of the range last week, but a selloff has moved the index below 3900 this week, suggesting neutral risk to reward.

Using the S&P 500 ETF SPY as a proxy, the index remains above the uptrend that began in October. A break below $380 or a bounce back above $400 would be notable. The balanced risk-to-reward based on Kass’ range suggests that active investors be nimble.

The playbook for long-term investors' should remain using weakness to dollar-cost average into the S&P 500 index in 2023. Historically, past bear markets have always, eventually, preceded new bull market highs. Taking advantage of weakness by buying the second half of a bear market can lower average cost, positioning portfolios best to rebound to prior peak levels. 

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