The US ISM PMI (Institute for Supply Management Purchasing Manager’s Index) (in orange) provides a reliable leading indicator to assess the changes in level of economic activity in the US manufacturing sector compared to the previous month. It is worthwhile to note that PMI readings have remained below 48 for the past quarter. From the chart, periods of economic contraction with a surge in unemployment rate (in blue) and downside in the S&P 500 (in red) follow when the PMI reading falls below 48 for sustained periods highlighted in 2001, 2008 and 2020. Also, the reliability of PMI data to predict the S&P 500’s trend is strengthened when we observe PMI readings did not fall below 48 during the decade-long bull run between 2009 and 2019.

Following the collapse of Silicon Valley Bank, the Fed discount window usage surged to an all-time high to over US$150bn, surpassing levels seen during past Global Financial and COVID crises. The Fed discount window (Federal Reserve lending to depository institutions) plays an important role in supporting the liquidity and stability of the banking system and effective implementation of monetary policy. It helps depository institutions manage their liquidity risks efficiently by providing ready access to funding and avoid actions that have negative consequences for their customers, such as withdrawing credit during times of market stress.

With the increased use of the Fed’s liquidity backstop, bank lending standards for small business tends to tighten. This leads to higher thresholds to obtain credit, thereby reducing loan demand from prospective borrowers across a wide array of business and consumer credit fronts. From the chart, given the most aggressive usage of the window in history, we can expect an aggressive tightening of lending conditions leading to a credit crunch in the US.

Data from the latest NFIB Small Business Optimism Survey in April reflected the real-time impact felt by small businesses to obtain credit. 9% of small businesses surveyed reported tightening credit standards, further supporting the reversal in trend since the lows marked in 2020. From the chart, the past few occasions where businesses reported tighter credit approval in 1991, 2000 and 2008 have been followed by recessions.

The chart documents the average returns for the S&P 500 in recessionary bear markets along with key events that happen in the months leading up and after a recession. We are likely to be in the 2nd stage now where credit has started to tighten, we can expect the first Fed rate cut to be around a quarter away before downside for the market accelerates as it heads nearer to recession.

Conclusion:

The recent rally in the US markets does not paint an accurate picture of the broad market’s strength given the low breadth and investors should brace for an upcoming surge in volatility with the Volatility S&P 500 Index (VIX) at its lowest reading since December 2021 and the current stage of “Greed” in the Fear & Greed Index. Economic indicators such as the US ISM PMI, Nonfarm Job Openings and current credit conditions also suggest high probability of an economic downturn ahead and the markets could experience a volatility storm where more downside is probable.

References:

https://seekingalpha.com/article/4590144-widening-credit-spreads-may-sink-stocks-as-volatility-surges

https://www.yardeni.com/pub/ecoindsmbus.pdf