The stock market is ending February on a decidedly wobbly note, raising questions about the durability of an early 2023 rally.
Blame it on stronger-than-expected economic data and higher-than-expected inflation readings that have forced investors to rethink their expectations about how high the Federal Reserve will push interest rates again.
“The idea that stock markets would rally sharply while the Fed was still raising and the market was underestimating what the Fed was going to do” seemed “untenable,” said Lauren Goodwin, an economist and portfolio strategist at New York Life Investments. . in a telephone interview.
Market participants have come around to the Fed’s way of thinking. In late January, federal funds futures reflected expectations that the Fed’s benchmark interest rate would peak below 5% despite of the central bank’s own forecast of a maximum in the range of 5% to 5.25%. Furthermore, the market was forecasting that the Fed would deliver more than one cut by the end of the year.
That view began to change after the release of a January jobs report on February 3 that showed the US economy added a much more than expected 517,000 jobs and showed the unemployment rate falling to 3.4%. , its lowest level since 1969. on better-than-expected January consumer and producer price index readings and Friday’s rebound in the core personal consumption expenditures price index, the measure of inflation favored by the Fed , and the market outlook on rates looks very different.
Participants now see the Fed raising rates above 5% and keeping them there at least through the end of the year. The question now is whether the Fed will raise its forecast of where it expects rates to peak at its next policy meeting in March.
That translates to a support in Treasury yields and a pullback in stocks, with the S&P 500 down around 5% from its 2023 high set on February 2, leaving it 3.4% year-to-date. year until Friday.
It’s not just that investors are learning to live with the Fed’s rate expectations, but investors are realizing that reducing inflation will be a “bumpy” process, said Michael Arone, chief investment strategist for the SPDR business at State Street Global. Advisors, in telephone interview. After all, he pointed out, it took former Fed Chairman Paul Volcker two recessions in the early 1980s to finally crush a runaway bout of inflation.
The S&P 500’s run to the February 2 high was led by what some analysts derisively called a “race to the trash.” The biggest losers of last year, including highly speculative stocks of companies with no earnings, were among the leaders on the comeback trail. Those stocks suffered particularly last year when the Fed’s aggressive cadence of rate hikes sent Treasury yields up sharply. Higher bond yields make it difficult to justify holding stocks whose valuations are based on projected long-term earnings and cash flow.
Inflation readings this month have been higher than expected, resulting in a “reversal of everything that was working” before, Arone said. The 10-year Treasury yield had fallen, the dollar was weakening, meaning highly speculative and volatile stocks are returning leadership to companies that benefit from rising rates and inflation, he said.
The energy sector was the only winner among the 11 sectors in the S&P 500 last week, while materials and consumer staples outperformed.
The Dow Jones Industrial Average DJIA,
fell 3% last week, leaving the top-line indicator down 1% so far in 2023, while the S&P 500 SPX,
fell 2.7% and the tech-heavy Nasdaq Composite COMP,
fell 1.7%. The Nasdaq pared its year-to-date gain to 8.9%.
Goodwin sees room for shares to fall another 10-15% as the economy slides into recession. He said that while the earnings results showed that the bottom line continues to hold up relatively well for the technology and consumer discretionary sectors, top-line revenue is slowing, a worrisome mismatch. Aside from the winners of the pandemic, companies are struggling to maintain profit margins, he noted.
In fact, margin issues could be the next big concern, Arone said.
Net margins are below the five-year average because companies have hit a limit when it comes to passing price increases on to customers.
“My view is that this will continue to be a drag on the stock’s outlook and that it’s a bit under the radar,” he said. That could explain why sectors that still enjoy high margins or can increase margins, such as the aforementioned energy and industrials, were outperforming the market at the end of last week.