Amada Agati:  

From a hawkish Fed pause to an earnings recession, there's no shortage of material for investors to navigate in this current environment. 

In this edition of Adding Alpha, we take a closer look at where the macro meets the micro as we continue to march toward recession later this year.

As expected, the Fed's May meeting brought another 25 basis point rate hike, taking the Fed funds rate to an upper bound of 5.25%, the highest level in 15 years.

Powell left the door open to potentially raising rates yet again if the data warrants it. So some are characterizing it as a hawkish pause coming at the June meeting. The Fed is in a difficult position as inflation drivers are starting to show signs of getting sticky, with core CPI still hovering around 5.5%. 

We just can't claim victory in the inflation battle when the long-term inflation target is 2% and we're still more than 300 basis points away. But with cracks beginning to form at a macro level, more recently, the markets may start to help the Fed by taking some of the inflationary fire out of the backdrop, which we think could justify the latest rate hike being the last of the cycle. However, with the labor market continuing to exhibit surprising strength and resiliency, the jury is still very much out on this point.

We just simply need to see more confirming data points. And of course, as has been the case for quite a while now, the market is continuing to fight the Fed like a kid in a candy store craving the sugar high for more policy accommodation.

The market is totally focused on not if, but when rate cuts will start later this year. That's right. Even after Powell explicitly said the Fed has no intention of cutting rates in 2023, the market is priced for not one, not two, but three rate cuts later this year.

My immediate reaction is hashtag delusional. That's a technical term for you, but I think it's probably safer for me to say this falls into a be careful what you wish for kind of mantra.

If the Fed really does end up cutting rates later this year, it's because something fundamental has broken down in the economy. So we wouldn't count on a positive market reaction.

In our view, rate cuts mean the Fed went too far and we're headed for a more severe economic contraction than our current base case for a mild recession suggests. With inflation still elevated and interest rates at restrictive levels, we're seeing that show up in deteriorating earnings.

We're more than halfway through first quarter earnings season for the S&P 500, and it's on pace to be the second straight quarter of negative growth.

While we're still waiting for the economic recession clock to start, the earnings recession is already here. But unlike last quarter, where the beat rate was one of the worst on record outside of a recession, upside surprise is over 700 basis points so far this earnings season.

So why isn't the market rallying when that should be viewed as very good news? Because earnings expectations for Q1 fell by almost 650 basis points before earnings season even began, making it one of the most severe negative revisions in the last 20 years.

Again, outside of a recession. Net net, we set a very low bar for ourselves and only a narrow subset of companies are presently leading the charge. If our outlook for a mild recession remains intact, then we would expect earnings then we would expect earnings to continue to come down from here.

Believe it or not, the S&P 500 earnings per share estimate is still about $229 per share, or only 4% off the cycle's peak of last summer. We think there's at least another 5 to 10% further downside from here.

It also means the expectation for a still positive 1% total S&P 500 earnings growth this year, followed by 12% earnings growth in 2024. We'll need to see some sizable resets. 

At current valuation levels, the market is simply not priced for an economic or earnings recession, and we've been saying this for months now. Given the dynamics in play, we are still tactically de-risking portfolios, running a defensive playbook and buckling in for what we think will likely be a fairly choppy summer.