More investors realize the Fed isn’t bluffing

ANTHONY SAGLIMBENE – CHIEF MARKET STRATEGIST, AMERIPRISE FINANCIAL

WEEKLY MARKET PERSPECTIVES — February 27, 2023

Interestingly, the 2-year/10-year U.S. Treasury spread continues to sit at some of its most inverted levels since the early 1980s. Over the last three U.S. economic downturns, a U.S. recession has followed once the 2-year/10-year spread has inverted (i.e., turned negative). Today, the mixed signals coming from economic data, combined with slowing earnings trends, rising yields, and a Fed determined to bring down inflation, have stock investors concerned the central bank will continue tightening monetary policy right into the next recession.

Investors with a bullish outlook continue to hold onto a ‘soft landing’ scenario; the bears can quickly point to headwinds

But the bulls continue to look through the backup in rates and an inverted yield curve, focusing instead on a solid labor market and positive macroeconomic surprises, such as the Citi Economic Surprise Index sitting at its highest level since April 2022. A soft-landing scenario is the central theme across this camp, with still benign credit conditions and consumer resilience as the pillars of support against a tightening Federal Reserve. But the bears can quickly point to equity headwinds, including a sharp backup in rates, falling earnings estimates, a higher for longer terminal rate, and stretched stock valuations. Combined, these bull/bear market dynamics show the investing environment remains highly fluid and uncertain at the moment, arguing for caution and a disciplined investment approach.

Outside of stocks and bonds, the U.S. Dollar Index rose +1.3% last week — posting its best week since September. The dollar has posted gains over four straight weeks following the steep decline from its September high to its late January low. West Texas Intermediate (WTI) crude settled the week down 0.3%, while Gold ended down 1.8%.

On the economic front, growth in the final quarter of last year, while positive, was less robust than initially reported after a second look at the data. Q4’22 U.S. GDP expanded +2.7% quarter over quarter annualized, following an initial reading of +2.9%. While the slight difference does little to alter the overall assessment of the final quarter of last year, hotter-than-expected inflation during the period reduced growth in real terms. Given that hotter-than-expected inflation trends are the Fed's primary focus today, the reduced growth in Q4 (due to higher prices) didn’t sit well with investors. Importantly, the Fed’s preferred inflation gauge also came in hotter than expected for January. Core Personal Consumption Expenditures (PCE) rose +4.7% year-over-year in January, well above the +4.3% expected. Along with upward PCE revisions for December and strong consumer spending in January, last week’s economic updates were not very market friendly. Meaning the Fed’s work to curb inflation and cool demand remains incomplete, which could pose more headwinds for stock prices in the months ahead.

The Fed continues to see inflation as a key risk to price stability, meaning they will likely push rates higher for longer

Regarding the Fed’s work, February FOMC meeting minutes showed all officials supported a 25-basis point hike at this month’s meeting, with a few favoring a 50-basis point move. And while all officials saw the benefit of slowing the pace of rate hikes, officials that supported a 50-basis point move believed moving quickly to a higher terminal rate would achieve sufficiently restrictive policy faster. As a result, the odds of a 50-basis point hike in the fed funds rate at the March meeting currently stands at 27%. One month ago, the figure was zero. Importantly, the minutes did not mention the term “disinflation” or make reference to a pause in rate hikes. Bottom line: The Fed continues to see inflation as a key risk to price stability, believes higher rates will likely help curb price pressures and is not signaling they are close to a pause, let alone considering cutting rates. Stocks dipped lower last week as more investors came around to the idea that the Fed will likely keep pushing rates higher this year and leave them at a higher rate for longer than was priced into the market just last month.

Looking ahead to this week, the economic calendar slows, with durable orders, home data, consumer confidence, and final looks at February manufacturing and services activity as the highlights. February manufacturing activity is expected to show levels remain in contraction while services activity continues to expand. And while the industrial side of the U.S. economy has been facing headwinds and slowing activity for months, the services side continues to experience tailwinds from pent-up demand, a tight labor supply, and an ability of companies to pass on costs. In addition, consumers focused on experiences, going to events, eating out, and traveling has contributed to a still strong services economy. Although we believe no one on the Federal Reserve wants to break the economy, expanding services activity (which could drive wages higher) certainly complicates the Fed’s job to curb inflation.

Companies continue to focus on inflation and controlling costs; stocks remained volatile as February comes to a close

In addition, the fourth quarter earnings season finally winds down this week, with 28 S&P 500 companies scheduled to report their results. With roughly 94% of S&P 500 fourth quarter reports complete, blended earnings per share (EPS) growth is down 4.8% year-over-year on revenue growth of +5.4%. The Index is on pace to record its first year-over-year EPS decline since Q3’20, with only 68% of S&P 500 companies surpassing earnings estimates. Notably, S&P 500 net profit margins declined in the fourth quarter, with nine of eleven sectors seeing margins pressured in the final three months of 2022. According to FactSet, fewer companies mentioned the term “inflation” on their fourth quarter earnings calls and relative to previous quarters. But the term remained a prominent theme across company commentaries and outlooks. Combined with reduced outlooks for net profit margins in the first quarter of this year, inflation, and companies’ ability to manage costs, remain a front-and-center issue for corporate America.

Finally, we expect stocks to remain volatile as February comes to a close and the final month of the first quarter kicks off this week. In its simplest form, volatility has been rising this month, as measured by the CBOE Volatility Index. Volatility in the S&P 500 Index is now above its three-month average but remains near its five-year average of 21. Bottom line: While February was more volatile for stocks, following the outsized jump in equity prices in January, some price giveback should be expected. However, how much giveback is appropriate is the real question. We suspect it will likely depend on how rates, the Fed, and macroeconomic conditions develop over the coming weeks and months. In our view, a cautious, disciplined approach that doesn’t lean too aggressively defensive is how most investors in the accumulation stage of their lives should navigate the current environment.