A U.S. recession may prevent a steep market downturn in the second half of 2023, according to Michael Yoshikami, founder and CEO of Destination Wealth Management.
U.S. consumer price inflation eased to 4.9% year-on-year in April, its lowest annual pace since April 2021. Markets took the new data from the Labor Department earlier this month as a sign that the Federal Reserve‘s efforts to curb inflation are finally bearing fruit.
The headline consumer price index has cooled significantly since its peak above 9% in June 2022, but remains well above the Fed’s 2% target. Core CPI, which excludes volatile food and energy prices, rose by 5.5% annually in April, amid a resilient economy and persistently tight labor market.
The Fed has consistently reiterated its commitment to fight inflation, but minutes from the last Federal Open Market Committee meeting showed officials were divided over where to go on interest rates. They eventually opted for another 25 basis point increase at the time, taking the target Fed funds rate to between 5% and 5.25%.
Chairman Jerome Powell hinted that a pause in the hiking cycle is likely at the FOMC’s June meeting, but some members still see the need for additional rises, while others anticipate a slowdown in growth will remove the need for further tightening. The central bank has lifted rates 10 times for a total of 5 percentage points since March 2022.
Despite this, the market is pricing cuts by the end of the year, according to CME Group’s FedWatch tool, which puts an almost 35% probability on the target rate ending the year in the 4.75-5% range.
By November 2024, the market is pricing a 24.5% probability — the top of the bell curve distribution — that the target rate is cut to the 2.75-3% range.
Speaking to CNBC’s “Squawk Box Europe” on Friday, Yoshikami said the only way that happens is in the event of a prolonged recession, which he said is unlikely without further policy tightening as falling oil prices further stimulate economic activity.
“This is going to sound crazy, but if we don’t go into slower economic growth in the United States and maybe even a shallow recession, that might be actually considered a negative because interest rates might not be cut or might even continue to go up if that’s the case. That’s the risk for the market,” he said.
‘Be skeptical’
Yoshikami believes more companies are going to begin guiding the market more conservatively on forward earnings in anticipation of borrowing costs staying higher for longer and squeezing margins.
“To me, it all really is gonna come down to ‘is the economy gonna touch near a recession?’ Believe it or not, if that happens, I think it will be good news,” he said.
“If the economy avoids it and keeps on its frothy path, then I think we’re going to have some problems in the market in the second part of the year.”
Federal Reserve officials, including St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari, have in recent weeks indicated that sticky core inflation may keep monetary policy tighter for longer, and could require more hikes this year.
Yoshikami said the actual process of cutting rates would be a “drastic move” despite market pricing and suggested policymakers may try to “massage” market expectations in a certain direction through speeches and public declarations, rather than definitive policy action in the near term.
As a result of the tenuous path for monetary policy and the U.S. economy, the veteran strategist warned investors to “be skeptical” of valuations in certain portions of the market, particularly tech and AI.
“Think about it, look at it yourself and ask yourself this question: is this a reasonable stock given what we think the earnings are going to be for the next five years? If it’s not, you’re putting an optimism premium on that asset that you better be awfully sure about because that’s where, really, tears come,” he said.