Can stocks climb higher as investors contend with uncertainty?

ANTHONY SAGLIMBENE – CHIEF MARKET STRATEGIST, AMERIPRISE FINANCIAL

WEEKLY MARKET PERSPECTIVES — February 13, 2023

The market's heartbeat slowed a little last week as the pulse of economic releases moderated and the rhythm of the fourth quarter earnings season persisted. Investors continue to synthesize impacts from a Federal Reserve nearing the end of its rate hiking campaign, though still contending with the uncertainty of exactly when the end comes and how high the fed funds rate will be as a result. In addition, soft landing/hard landing concerns for the economy play in the background, as does an earnings backdrop that has been less than encouraging.

The fourth quarter earnings season has largely underwhelmed, with fewer companies than average surpassing already low expectations heading into the reporting season. However, consumer resiliency, “less bad” outlooks, cost-cutting measures, improving supply chains, and a greater focus on expense management have been bright spots in the aggregate that investors appear to be gravitating toward to help drive the overall earnings narrative. As a result, stocks appear to be moving through the earnings season in a relatively solid fashion — despite declining profit estimates for the first two quarters of this year. With roughly 69% of S&P 500 fourth quarter reports complete, blended earnings per share (EPS) growth is down 4.9% year-over-year on revenue growth of +4.6%. The Index is on pace for its first year-over-year EPS growth decline since the third quarter of 2020. This week, the rate of earnings reports will slow, with 61 S&P 500 companies scheduled to release results.

Last week, the S&P 500 Index was down 1.1%, falling for the first time in three weeks. Similarly, the NASDAQ Composite slid lower by 2.4%, breaking a five-week winning streak and posting its worst week of performance since mid-December. And despite the value-based Dow Jones Industrials Average (down 0.2%) helping moderate losses on the week, Value underperformed Growth for the fourth time in five weeks. Energy (+5.0%), Healthcare (down 0.2%), and Utilities (down 0.4%) helped to mitigate some of the pressure across the S&P 500. Conversely, traders lightened exposure to Communication Services (down 6.6%) and Consumer Discretionary (down 2.2%), following both sectors seeing an impressive start to the year.

Stocks give back some performance; rates unlikely to come down in 2023, according to the Fed

Notably, stocks gave back some of their strong year-to-date performance last week due to higher bond yields taking a bite out of a key tailwind for higher stock prices in 2023. The Fed-sensitive 2-year U.S. Treasury yield climbed to its highest level since November, finishing the week at 4.51%. The 10-year U.S. Treasury yield ended last week at 3.74%, its highest level since the start of the year.

Earlier in the week, Federal Reserve Chair Jerome Powell retread his post-FOMC comments in an appearance at the Economic Club of Washington. And while he again stated disinflation pressures have begun, he repeated there is a long way to go to bring down inflationary forces. Importantly, he sees more rate increases on the horizon. In our view, investors are finally beginning to absorb what Mr. Powell has been saying for months. That is, rates are moving higher and unlikely to come down in 2023. As a result, the market is now pricing in a peak fed funds rate of 5.15% and one rate cut by the end of the year. This is up from 4.90% and the anticipated two rate cuts in 2023 following the Fed’s policy announcement on February 1. Note: The top end of the fed funds rate currently stands at 4.75%. Combined with the 2-year/10-year U.S. Treasury curve hitting its most inverted level since the 1980s last week, recession fears continued to grow and contributed to a modest stock retreat.

Bottom line: Everyone should expect the Fed to press rates higher from here. But the market still doesn’t buy the idea Mr. Powell and company won’t need to cut rates this year. And that’s because investors fear growth may slow considerably by the end of the year and pressure the Fed to ease policy in an effort to help support the economy. But the verdict is still out on that outlook, and we believe that assessment inserts risk for asset prices should the Fed actually do what they have been telling the market they intend to do. In a nutshell, the mixed dynamics around rates, monetary policy, and the growth outlook had traders taking a breath last week and moving some of their chips to the side ahead of this week’s January CPI report.

The dollar rises; consumer sentiment improved modestly

Outside of stocks and bonds, the U.S. Dollar Index rose 0.6% last week, Gold lost 0.2% to finish at $1874.70, and West Texas Intermediate (WTI) crude jumped +8.6%, ending at $79.82.

Preliminary February Michigan Sentiment improved over January’s final reading, with consumers’ view of current conditions moving higher and their view of expectations dipping lower. Notably, consumers’ view of one-year ahead inflation jumped to +4.2% in February from last month’s +3.9%. Although five-year inflation expectations remained unchanged at 2.9% for the third straight month, we doubt the report will encourage the Fed to do anything but raise rates over the near term. Consumers in the survey continue to worry about higher prices, despite a recent moderation in inflation. However, building concerns about rising unemployment may help to weigh on consumer spending in the months ahead, which could influence inflation expectations over the next few reports.

Speaking of inflation, the Bureau of Labor Statistics will release the January Consumer Price Index (CPI) on Tuesday. The key inflation report will be the week's highlight, with investors keenly focused on the direction of prices at the start of the year. FactSet estimates suggest headline CPI fell to +6.2% year-over-year in January and following the +6.5% pace in December. Core CPI (ex-food and energy) is expected to have fallen to +5.4% last month, also down from the +5.7% pace recorded in December. However, on a month-over-month basis, headline CPI is expected to bounce higher in January on higher energy and food prices. Bottom line: The market wants to see if disinflationary forces across the economy are continuing to help moderate the most closely watched inflation gauge in the U.S. And while each month’s update may not always show a smooth glide path lower, the Fed’s persistence at leaving monetary policy restrictive should result in inflation pressures moderating over the course of the year. And as the large spikes in inflation in the front half of 2022 begin to roll off the year-over-year measure, we suspect investors may become less concerned about the direction of inflation. However, falling inflation concerns are likely to be replaced with growing anxiety about the pace of economic growth this year, all else equal.

Retail sales likely to get investors’ attention this week; fundamentals need to improve to support stock strength

January retail sales (Wednesday), the January Producer Price Index (PPI) on Thursday and housing data this week line the rest of the economic calendar. The retail sales report should garner some market attention this week, with January’s figure expected to rebound +1.6% month-over-month following December’s decline of 1.1%. A pop in gasoline prices and strong vehicle sales last month could positively influence the retail sales report. But we expect consumers to rebuild savings as growth slows and recession worries continue. According to Action Economics, the savings rate fell to a 17-year low in the third quarter of last year, marking the second lowest rate in the series dating back to 1959. While consumer balance sheets remain strong, we suspect the absence of fiscal stimulus and a desire to hold more savings for a rainy day could eventually weigh on spending more broadly at some point this year.

Lastly, traders will likely test the 4,100 level in the S&P 500 this week. Following the market’s rally early this year, a higher percentage of companies in the Index are currently trading above their longer-term trading range after the Index’s overall figure collapsed in September of last year. This tends to be a positive and lasting sign for market breadth and support. Bottom line: Some technical conditions have improved since late last year, and we believe investors should welcome the change. However, investors have aggressively run cyclical/growth areas higher while the near-term fundamental catalysts (e.g., earnings growth and demand drivers) are not particularly favorable, in our view. Eventually, we believe investors will have to square these two contrasting points, and fundamental conditions will likely need to improve as the year wears on to support ongoing stock strength.