Since you last heard from us in our Quarterly Commentary, markets have continued to move higher, buoyed by the belief that inflation is finally falling, and that the economy may indeed achieve a ‘soft landing’ needed to avoid recession. While the verdict is certainly still out on this, recent economic data has supported a slightly rosier outlook of late, which is why markets have now retraced roughly 40% of their peak to trough move. But as we’ve seen previously, with higher prices comes higher expectations, which is likely to drive volatility in the near term.
On the data front, the most notable improvement in recent weeks is the continued progress on inflation, particularly wage growth, which is a major feeder into inflation. Consumer goods prices are also starting to move lower even as services remain quite elevated. These dynamics have contributed to a moderation in monthly inflation rates to approximately 4% annualized from the 7-8% they were at this time last year. While still double the Fed’s target of 2%, it has nevertheless been material enough of a decline for the Fed Chair to acknowledge in his recent Q&A as evidence that disinflation is in fact beginning. This acknowledgement has helped to convince the market that rate hikes are indeed nearing an end, in turn fueling the recent rally in stocks. This has been particularly true in the tech and growth stocks which are most sensitive to interest rates.
Other positive data points have included the 4th Quarter GDP print of 2.9%, which shows the economy still in expansion even as it slows, and a blowout January jobs report showing over 500k new jobs created and a 3.4% unemployment rate. This comes even as certain pandemic-boosted sectors such as technology and financial services announce large layoffs. These ‘hard data’ points are certainly helping to paint a more optimistic outlook of the economy than the gloomier ‘soft data’ borne out of consumer and CEO surveys. In other words, the economy in total is broadly doing better at this point than people think or feel it is.
This is undoubtedly a welcome development from just a few months ago when consensus expectations was more pessimistic. However, this dynamic is also creating a sensitive game of expectations for the market. The Fed has stated very clearly that they believe there is still a ways to go before they are satisfied on inflation. If the economy or labor market remains too strong, they may end up hiking interest rates higher or holding them higher for longer than the market is currently pricing in, which would likely cause a partial reversal of recent moves.
Another important piece of the puzzle is corporate earnings, which continue to weaken as consumers and companies peel back their spending. Earnings growth on the S&P 500 has finally stalled out and even recently dipped into negative territory as the impact of Fed policy and inflation makes its way through the economy. While analysts are actually starting to become more bullish, this represents a risk to the market going forward. In particular, the higher and longer the Fed goes, the more you’d expect earnings to be impacted.
Nevertheless, recent movements in the market show that investors are comfortable with these risks given stocks are now at much more reasonably priced valuations. The PE ratio on the S&P 500 for example, is down over 40% from its recent high, a much greater decline than the 15% decline experienced by the index itself. This dynamic was clearly on display with disappointing earnings from the mega-cap tech names recently. While the ‘FAANG’ group largely reported declining revenues, their stocks rallied after dovish commentary from the Fed overwhelmed the negative sentiment.
This disconnect illustrates well the current tug-of-war between monetary policy and earnings fundamentals. The former has largely won out over the last 6 weeks, but the latter is likely to take the driver seat the longer this dance goes. While this uncertainty is somewhat elevated given how close we are to the end of a hiking cycle, its par for the course for markets of late, and with the volatility comes opportunity to add value in portfolios. In particular, after adding some new positions in the market lows we are now tactically raising cash in select portfolios that need it, such as those in margin or with high withdrawals. We remain as vigilant as ever in looking for new opportunities, and already laying the groundwork for our next high-quality purchases when the market gives us that opportunity.