Weekly market wrap

Fact or Fiction? Addressing Popular Market Proclamations

Key Takeaways:

• 2023's stock market rally rolled on last week, helped by a downshift in Fed rate hikes, with the S&P 500 now up nearly 8% on the year. Interest rates took a bit of a round trip, falling through the week on expectations for less restrictive Fed policy but rising on Friday following a strong jobs report⁴.
• The January employment report released on Friday showed that the economy added a whopping 517,000 jobs last month, more than double the consensus forecast. While other parts of the economy are showing signs of slowing, the healthy labor market should offer support for consumer spending, helping moderate a potential downturn.
• Stocks and bonds have risen materially in recent months. We don't think the stock market has to give back all of these gains, but we do think investors should anticipate a choppier path ahead, as incoming data reshapes expectations for economic activity, earnings growth and Fed policy.

After a year (2022) in which nothing seemed to go investors' way, 2023 has, so far, been the polar opposite. Stocks are up handsomely while interest rates are down. Last week brought a heavy dose of fresh information on what we'd consider to be the two critical drivers for the market this year: the Fed and the labor market. The outcome was another up week for the market – its fourth in the first five weeks of 2023.

While this recent rally is both welcome and reasonable, we don't think it should be viewed as confirmation that the coast is clear.  Given what we learned last week, here are our latest thoughts on several popular takes that prevailed heading into this year:

The Fed is overdoing it with rate hikes.

• Fact and Fiction. The distinction lies in the context of necessity and broader outcome.  In our view, it's been necessary for the Fed to take aggressive action to combat high inflation.  Has it tightened (raised rates) to a point that threatens to undermine economic growth? We think so. Monetary policy acts with a lag, so we have yet to see the full impact of the Fed's actions. So should the Fed have stopped earlier to prevent a slowdown?  No. While we certainly would prefer monetary conditions that are accommodative to robust GDP growth, underdoing it runs the risk of reigniting inflation that would pose greater structural threats to the economy. Put simply, we think the Fed is willing to exert some near- and short-term pain on the economy in exchange for avoiding a scenario like we experienced in the early-'80s. 
• Stocks rallied last week following the Fed's latest meeting in which it announced a 25-basis-point (0.25%) rate hike. Markets found comfort in a few elements of the announcement:
  • This marked a downshift in the pace of rate hikes, with the previous six hikes being 0.5% or larger⁴.  
  • The Fed acknowledged that disinflationary forces are taking shape, suggesting it feels it's making progress⁴.
  • The Fed did not make special or dramatic efforts to push back against the recent evidence of easing financial conditions (which include measures such as access to, and cost of, credit)⁴.
• Overall, our takeaways from the Fed's announcement are
  • This phase of rate hikes is nearing an end; and
  • While the markets cheered the fact that the Fed didn't go out of its way to clobber rising optimism around a coming pivot in interest-rate policy, we don't think the Fed is in love with the loosening of financial conditions or market expectations for rate cuts.  We would not be surprised to see Fed officials out on the speaking circuit attempting to rein in expectations and prevent the market from moving too far ahead of policy actions.
• It is abnormal for the Fed to be executing rate hikes at the same time that a wide swath of economic activity measures are slowing or contracting. But these are not yet completely normal times, and we think the Fed will need evidence that inflation is fully stamped out before it can resume a more responsive stance. We suspect the Fed will first move to the sidelines, pausing after one or two quarter-point hikes, and then begin to acknowledge a more accommodative shift later this year. The markets appear at the moment to be slightly too optimistic towards the expectation for multiple rate cuts in 2023. We think the conversation around easing policy will pick up in earnest at some point in 2023, but the actual implementation of material rate cuts will be fully dependent upon a material and sustained drop in inflation back toward the Fed's 2% target.
• We think the end of the Fed's tightening cycle is a requisite for a new, sustained bull market to take shape. Markets typically do well when the Fed stops hiking rates, and we think this time is no exception.  However, we don't expect this condition to play out immediately or seamlessly. Investors can find comfort in the progress signaled by this latest Fed announcement, but markets are still likely to exhibit some spates of anxiety, as it takes time for the Fed's audio and video to fully sync up.

Just look at the price of eggs. Inflation is still out of control. 

• Fact and Fiction. Admittedly, if you're making an omelette, prices still appear to be skyrocketing.  However, a broader look at consumer prices reveals a much more favorable trend. It's a fact that overall inflation is still elevated, but it's fallen markedly from its peak and should continue to decline toward a more manageable level ahead.   
• Several key elements of inflation that drove last year's spike have reversed course, setting the stage for further moderation in consumer prices. Oil is down 40% from its peak last year⁴. Used-auto prices are contracting after an unprecedented surge. Supply-chain bottlenecks are clearing, driving a significant drop in goods inflation. And importantly, shelter costs are softening as the housing market cools (This has masked the underlying decline in inflation recently, as shelter prices are slower to recede. Excluding shelter, the core consumer price index has seen an outright decline for three straight months).
• Inflation is far from a nonissue at this stage, but an analysis of underlying factors gives us confidence that it is poised to moderate rather materially ahead. Falling inflation poses a few notably positive implications:
  • Real wages (adjusted for inflation) are boosted, offering support to consumer spending and helping soften an economic slowdown.
  • The real effective fed funds rate, which is currently around 0%, would move higher. This would effectively be a further tightening of monetary-policy settings. However, this could lessen the need for the Fed to implement several more rate hikes, and it could potentially support the case for the Fed to ease off the brake sooner than it otherwise expects.

Layoffs are just getting started, and spiking unemployment will bring a recession.

• Fiction, though some qualification is required here.  Our base-case expectation is that a mild recession will emerge this year. However, we'd underscore the mild part, with the labor market playing a key supportive role in staving off a more severe downturn in the economy.
• While several underpinnings of the economy are contracting or trending toward that, nobody told the labor market. The January employment report released on Friday showed that the economy added a whopping 517,000 jobs last month, more than double the consensus forecast. Payroll gains were broad-based, with healthy additions across the leisure & hospitality, retail, manufacturing, health care and construction sectors.
• The unemployment rate fell to 3.4%, a number last seen in 1969.  1951-1953 is the only post-war period in which unemployment was lower.  This was particularly positive given an increase in the labor force, which signals that more people are joining the workforce and finding jobs when they get there. Further, average hours worked moved higher, which, when coupled with separate data showing job openings increased to 11 million, offers additional signs of ongoing robust demand for labor.
• Perhaps the most important figure from this report, however, was the latest read on wages. Average hourly earnings growth slowed again in January, to an annualized pace of 4.4%, down from 4.8% in December1. While any moderation in wages may not sound like a positive thing, this should offer some comfort to the Fed that wages are not exerting upward pressure on inflation.
• The bottom line: This latest read on the labor market is categorically positive for consumers and the economy. However, we think it's premature to consider a potential recession canceled.  While this does support our view that the healthy starting point for employment conditions will make a downturn much more mild (including our expectation for a smaller-than-average increase in the unemployment rate), we also think this complicates the Fed's job ahead.  We're not sure that this sweet spot of strong job gains and historically low unemployment, alongside moderating wage growth, can persist indefinitely.  We suspect the former will give and we'll see some softening of the labor market ahead.

There's too much bad news out there. The place to be is on the sidelines in cash.

• Fiction. We don't disagree that there are still credible risks in this investment environment, but we believe – and history shows –the times that may feel the worst can make for the best market opportunities. 
• Look no further than the last three months as affirmation of the value of remaining invested and disciplined within a bear market. U.S. equities are up 16% since mid-October¹. International markets have done even better, rising 28% from their late-2022 low⁴. The rally has not been confined just to stocks. Bonds have gained 9% since mid-October as well, benefiting from the drop in interest rates.
• To be clear, markets have had a sharp run in a rather short time, and we think a bit of complacency has set in. That may be hard to believe with stocks falling into a bear market last year and bonds experiencing their worst year on record. However, we think recent market sentiment has grown slightly too optimistic to the idea that the Fed will shift quickly to rate cuts (markets last week were pricing in 0.50% of Fed rate cuts in the second half of this year). The VIX index, often referred to as the "fear index" because it is a measure of market volatility, fell below 18 last week for the first time in more than a year, down notably from an index average of 24 over the last six months.2
• We don't think the stock market has to give back all of these gains, but we do think investors should anticipate a choppier path ahead, as incoming data reshapes expectations for economic activity, earnings growth and Fed policy. Meanwhile, showdowns in Washington over the debt ceiling and budget, as well as global geopolitical uncertainties, are likely to spur bouts of anxiety.
• All that said, we think the foundation of a new bull market and economic expansion will take shape as we advance through the coming year. With cash and CD yields having risen to their most attractive levels in some time, we think a systematic strategy to put excess cash and maturing CDs to work within long-term equity and bond portfolio allocations will be rewarding, allowing you to benefit from a broader recovery as well as any short-term pullbacks that emerge along the way.

Craig Fehr, CFA
Investment Strategist

^{Source: 1. Bureau of Labor Statistics. 2. Bloomberg, CBOE Volatility Index (VIX). 3. Bloomberg, total return of the S&P 500 Index, MSCI EAFE Index and Bloomberg U.S. Aggregate Bond index. 4. Bloomberg}

Weekly market stats

^{Source: Factset. 02/03/2023. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Source: Morningstar, 02/06/2023.}

The week ahead

Important economic data coming out this week include wholesale inventories and consumer credit.

Review last week's weekly market update.