• Equity markets may be in the midst of their first correction since late summer/early fall of last year. Although this recent downturn may ultimately prove to be just a pullback from the surprisingly strong first quarter performance, concerns are growing that the Federal Reserve (Fed) may not ease at all this year, as progress on bringing inflation down to the 2% target has stalled. Even at current inflation rates, the real federal funds rate may be too high and could eventually choke economic growth. Rising geopolitical tensions are also inducing some profit-taking in equity markets while stronger-than-expected first quarter gross domestic product (GDP) growth and hotter inflation are pushing bond yields up to levels that provoked the last correction.

Retail Sales Reflect Enthusiastic Consumers

  • The U.S. consumer’s year got off to a strong start reinforced by March retail sales, which were up 0.7% month over month, beating the +0.4% estimate, while February was revised up 0.3 points to +0.9%. The control group subsector, which eliminates automobiles, gasoline, and building products, did even better, up 1.1% compared to the +0.4% estimate. As with February, it was also revised 0.3 points higher. Online and general merchandise stores were particularly strong, as consumers on the higher end of the income spectrum were especially ebullient at the end of the quarter.
  • With the strong retail sales report, the Atlanta Fed’s GDPNow forecasting tool is predicting 2.8% growth when the first estimate of 1Q GDP data is released on Thursday. Real consumer spending likely grew over 3% on higher disposable income and savings drawdowns.

Magnitude of the Housing Recovery Remains Uncertain

  • Housing data published last week called into question the magnitude of the recovery we have been seeing in the sector.
    • March housing starts were down 14.7% from an upwardly revised February, as the unseasonably warm weather boost to February was reversed. The more forward-looking building permits decreased 4.3%, as prospective buyers appear to be hesitating until they understand which way interest rates are heading. March existing home sales were down 4.3% month over month, but they beat estimates and were up close to 8% for the quarter. Some loosening in inventories and the lower mortgage rate environment at the beginning of the year helped boost sales, but inventories are still historically tight, which is keeping prices high. The recent increase in mortgage rates is also impacting buyer affordability as the sector enters the second quarter.
    • Homebuilders remained generally confident in their outlook as reflected in the April NAHB/Wells Fargo Housing Market survey, which remained at 51 and was in line with estimates. With tight existing home inventories and secular demand from first-time homebuyers, builders will need to fill the product shortfall.

Manufacturing Slowdown May Have Finally Bottomed

  • Businesses remain somewhat reticent in their outlook, although the purchasing managers’ surveys are beginning to acknowledge the reality of a bottoming in the manufacturing slowdown we experienced in the second half of last year.
    • While the New York region saw continued contraction in its April survey, there was a slight improvement to -14.3 from -20.9 in March. The more manufacturing-based Philadelphia regional survey was much more optimistic, as it defied expectations of a slight contraction. It rose to +15.5, a notable improvement from the +3.2 increase in March. It was the third straight positive monthly reading, as new orders saw a strong pickup. Interestingly, both surveys saw weaker employment growth but higher prices paid, which may have an offsetting impact on the inflation outlook for the coming months.
    • Beyond the surveys, actual business spending grew slowly in the first quarter. March industrial production increased 0.4%, in line with estimates and commensurate to a 0.4% increase in February, which was revised from the originally reported +0.1%. Boosted by higher automobile production, manufacturing production was up 0.5%, better than the +0.3% estimate. Looking forward, the effects of the federal government’s CHIPS and Science Act should drive production in the technology space into 2025. Also, there is no apparent need to work off excess business inventories, as February inventory growth of 0.4% did not match business sales growth of 1.6%, allowing the inventory-to-sales ratio to fall to a historically manageable 1.38%.

Geopolitical Strife and Less-Dovish Fed Drive the Market Pullback

  • Moving to the simmering geopolitical front, Israel finally retaliated Friday morning for the Iranian bombing the previous weekend by striking an air force facility inside Iran. Iran downplayed the damage from the drone missile attacks, which reduced the risk of an immediate response. Importantly, there was no damage to nuclear sites from the retaliatory attack, and the United States received last-minute notice and was not involved. Political analysts (and markets) view this as a controlled act that would allow both countries to save face. U.S. equity futures and foreign markets gapped down right after the attack but then recovered somewhat, although U.S. equity markets struggled in the final hours of trading for the week. West Texas Intermediate crude oil spiked up to $85 per barrel before quickly reversing down below $82.
  • Reiterating one of the points discussed on last week’s client call, the S&P 500 Index has an average intra-year drawdown of 14%, as measured over the last 45 years. This is the price one pays (volatility) for an average annual return of 9.1% (geometric average). The current drawdown is 5.5% from the last March peak. There is always a reason for the pullback and, as mentioned above, a less-dovish-than-expected Fed combined with geopolitical strife is this episode’s catalyst. Still, economic strength and profit growth give some reassurance that this pullback, while perhaps not finished, is unlikely to lead to something worse than a correction

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