Bulls Take the Reins in 2023
Equity markets have had a strong start to 2023 with the S&P 500 returning 6.65% year-to-date while the tech-heavy Nasdaq has surged 13.14%. This is largely thanks to market participants interpreting economic data as evidence that a Fed dovish pivot is imminent (that the Federal Reserve will soon stop hiking interest rates and will be in a position to cut them). Better price action in stocks has started to convince some investors they are missing the next bull market, compelling them to participate. The foundation for this more positive narrative consists of China reopening, falling inflation/U.S. dollar, easing supply chain bottlenecks, and that a Fed pause is on the horizon to name a few.
This line of thinking stands in contrast to leading indicators like PMIs falling alongside chronically inverted yield curves. While income and spending remain robust, labor remains tight, and growth is tepid. While the Fed is still in restrictive mode and is not indicating any interest rate cuts yet, rates markets disagree. In our current situation, we have slowing growth and a Fed that is still tightening. Although they are likely to pause soon, they are still doing $95B a month of quantitative tightening and are potentially far from cutting rates. This is not a friendly backdrop for equities.
Investors watched closely as Fed Chair Powell gave remarks today at the Economic Club of Washington. In summary he stated: that disinflation has started but still has a “long way to go;” that further rate increases are needed; that it will take a “couple years” to reach 2% inflation; a couple years to lower the balance sheet; and that the Fed does not want to surprise markets. Markets seesawed following the comments as traders assessed his comments.
One can look back at the inflationary period of 1965-1982 to see what can happen when policy is loosened too quickly. The market’s optimism, which could be keeping financial conditions looser than the Fed would like, might make it more likely that the Fed keeps tightening policy. So, all things considered, the risk of over-tightening seems to be higher than the likelihood of a premature pivot.
Just over half of the companies in the S&P 500 have reported earnings for the last quarter of 2022. Through last week, approximately 70% had beaten analyst forecasts for per-share earnings, one of the lowest rates of the past decade according to FactSet. Forward earnings per share growth have just gone negative. This has only previously happened 4 times over the past 23 years. In each prior instance (2001, 2008, 2015, 2020) equities have faced significant price downside associated with the shift from positive to negative earnings growth according to Morgan Stanley’s Mike Wilson.
Earlier this year, futures markets were pricing in interest rate cuts of roughly 50 basis points in 2023 and almost 150 basis points in 2024. Given the comments today, monetary policy would need to change dramatically from its current stance. While bond markets disagree, if we see expectations of the Fed’s terminal rate tick higher, then that would take the air out of the sails of the recent equity rally.
We continue to expect markets to be choppy as participants grapple with the conflicting data points. All eyes will be on Biden’s State of the Union speech tonight to a joint session of Congress considering renewed tension with China, and an imminent showdown with House Republicans over raising the federal debt ceiling.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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