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SUMMARY
- Inflation expectations have risen sharply over the last month, causing government bond yields to spike.
- Stocks have corrected but have demonstrated underlying resiliency, a positive sign, in our view.
- We remain cautiously optimistic on the stock market for 2023.
After a storming start to the year in January, both stocks and bonds pulled back in February. The culprit, in our opinion, has been the market’s recalibrated view of Federal Reserve (Fed) policy in the face of persistent inflation and economic growth signals. For instance, recent inflation data such as the Core Personal Consumption Expenditures (PCE) index, less food and energy, stopped falling in January, and increased more month-over-month than economists were expecting. The US economy also continues to outperform expectations. The Atlanta Fed’s GDPNow tracker estimates the US is trending towards 2.25% real GDP growth for Q1, and the employment market has continued its strength in February. Inflation expectations for the next year implied by derivative markets have increased markedly, from below 2% in mid-January, to over 3% today (see chart, below).
Inflation Expectations Rose Sharply in February
This strong inflation and growth impulse has sharply increased market expectations for interest rate hikes throughout the rest of ’23. Consider that, according to data inferred from fed funds futures markets, at the start of February the market was placing an approximately 80% probability of a year-end fed funds rate lower than 5.0%. However, by the end of the month, that probability had plummeted to under 10%. This major shift in rate views has had a direct negative effect on government bond pricing, with the 10-year treasury now back up close to 4%. This in turn has had an indirect effect on US stock valuations, where rate-sensitive growth sectors such as technology tend to dominate indexes like the S&P 500.
More hopefully, two leading indicators of inflation suggest inflation may ease. The National Federation of Independent Business’ (NFIB) ‘Propensity to Raise Wages' survey has started to turn down and aggregate money supply growth (M2) is negative. These indicators have historically been positively correlated with inflation, and thus we think the recent moderation in both point to some hope for inflation to continue to ease.
Our View: Fed Likely to Remain 'On the Case' in Hiking Mode
We do not believe this Fed wants to repeat the mistakes of the late 1970s, whereby the Fed was forced to reverse course and hike interest rates multiple times to finally get inflation under control – a theme we discussed in our 2023 Outlook back in December.
Thus, given the disparity between the Fed’s 2023 forecasts for Core PCE of 3.5% versus its current 4.7% level and the continuing strength of the labor market, we believe the Fed still has more work to do. Throughout any rate hiking campaign of the past five decades, the Fed has never stopped hiking before the funds rate was above Consumer Price Index (CPI). Against this backdrop, we now believe that we could see at least another 100 bps of rate hikes on the horizon.
Stock Market Technical Update: Recent Uptrend Still Appears Intact
Equity markets have been surprisingly resilient in the face of this recalibration in the bond market. The last few weeks of weakness have certainly called into question the stock uptrend, but in our view market internals remain generally constructive.
We feel that market bottoming is a process, not a single event. A number of bullish signals on the S&P 500 still suggest to us that the bottoming process is in its late stages, with the ultimate bear market low for this cycle likely made in October. We would especially note the flattening of the primary trend (200-day moving average–see red line on chart to the right), a breakout above that trend, and a recent ‘Golden Cross’ (when 50 day moving average – as represented by the green line - crosses above the 200-day; see orange circle on chart). The current level of the 200-day moving average is around 3940; we regard this and 3800 as the next important levels of support.
The stock pullback in February also makes sense to us in the context of extended crowd sentiment. A strong January drove near-term investor sentiment readings (as measured by sentiment polls such as Ned Davis Research’s (NDR) Daily Crowd Sentiment Poll and the American Association of Independent Investors - % Bullish - % Bearish index) up to levels associated with extreme optimism – a condition that often precedes a short-term market consolidation or pullback. It is worth noting that neither NDR’s Daily or Weekly Crowd Sentiment polls, nor the AAII poll, are currently in optimistic levels. This suggests to us that February’s market pullback has taken some of the froth out of trading sentiment– a contrarian positive, in our view.
Conclusion: Stock Market and Portfolio Implications
We share the market’s recent concern that the Fed is still in monetary tightening mode and that interest rate hikes are likely to continue for the foreseeable future. However, at RiverFront we also believe in the ‘message of markets’. Stocks and credit markets have remained resilient even as bond yields have spiked. We think it is a positive ‘message’ that these risk markets are willing to look through the recent inflationary impulse. We are sticking with our forecast made in our 2023 Outlook that stock markets are likely to have positive returns in 2023 but admit that the stock market is likely to remain volatile in the near-term.
Given the uncertainties and lower visibility into both the economy’s trajectory (see our Weekly View from 1/31/23 on our views of recession risk) and Federal Reserve policy, RiverFront’s investment team remains somewhat cautious in our portfolio positioning. We remain neutral to slightly overweight equities relative to our policy benchmarks, depending on portfolio time horizon and risk tolerance. As rates have moved higher, we plan on being opportunistic regarding adding bond duration to the portfolios.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.