Coming into 2023, markets had been pricing in two 25 basis point (0.25%) interest rate hikes, one in February and the second one at the next Fed meeting on March 21-22. In addition, there were expectations of an interest rate cut at the end of the year. All macro-economic indications suggested that with inflationary pressures easing, the Fed would be moving closer to its final “terminal” rate by the second half of the year. The only question was would the Fed stay on hold throughout 2023 before lowering rates in 2024, as suggested by a consensus of Fed members.
The fed funds futures market quickly adjusted probabilities as well, pricing in a potential third interest rate hike at the Fed’s June meeting. What has caught the market’s attention, however, is the slight probability for a 50 basis point rate hike at the March meeting has been climbing higher, as two non-voting members of the Federal Open Market Committee (FOMC), Loretta Mester and James Bullard, made comments suggesting a 50 basis point rate hike in March may be necessary to help tackle inflation. Markets are listening, which can be seen in the change in market-implied Fed rate targets for this year.
Important data releases before the March 21-22 meeting will help underpin the Fed’s monetary policy trajectory. The February 24 release of the Fed’s preferred inflation index, the Personal Consumption Expenditures Price Index (PCE), will be especially important in forecasting the Fed’s next policy decision. Similarly, comments from Fed officials will also help guide markets regarding the Fed’s thinking regarding its rate hike campaign.
A difficult fourth quarter earnings season is entering the home stretch, and the numbers have been lackluster. S&P 500 earnings per share (EPS) for the quarter are tracking to a roughly 4% year-over-year decline, slightly below estimates at year end. Slower economic growth, cost pressures from higher inflation, and ongoing adjustments from excess pandemic related spending have combined to create an especially challenging earnings environment. The result will be the first year-over-year earnings decline since the third quarter of 2020.
Despite lackluster overall results, there is a silver lining amid the sea of red numbers. Earnings estimates for 2023 have been widely considered to be too high based on historical earnings declines in recessions. The consensus estimate for S&P 500 earnings this year has come down 3% since the year began, lowering the bar. Earnings estimates have not collapsed, but corporate America has brought expectations down. Cautious guidance has made estimates more realistic.
Much has been written about how the laggards of 2022 have been the winners of 2023. Value stocks held up much better than growth stocks last year, and this year growth is leading. Last year’s worst performing sectors, consumer discretionary, communication services, and technology, are this year’s top performers, each with double-digit year-to-date percentage gains. At the individual stock level, the reversal is stark. The 50 worst performing stocks of 2022 have gained an average of 21.8% year to date.
Last year, stocks and yields moved mostly in opposite directions. When inflation expectations and interest rates moved higher, stocks tended to sell off and vice versa. But we have seen this relationship change recently, as stocks and yields have risen together. Specifically, since January 25, the 10-year Treasury yield has risen roughly 50 basis points while the S&P 500 has gained 2%. That’s not much, but it suggests a more resilient equity market in the face of higher than expected inflation data. Last year, the market response to pricing in more Fed rate hikes would have been much more negative.
There are several implications from these changes in the economic and market environment:
- More volatility in the near term. First, though this may be obvious, markets may be bumpy in the coming weeks and months because it will take more time to fully price in the end of the Fed rate hiking cycle. Market-based interest rates, such as the 10-year Treasury, may go higher than anticipated when the year began, potentially putting pressure on stock valuations.
- Possible barbell year. The lowered bar for earnings should help stocks over the balance of the year, though that benefit may not come until the fall. There is a possible scenario where estimates dip below the consensus forecast before upside late in the year gives earnings—and stock prices—a lift. That means we could see a solid start for stocks and a solid finish, with weakness in between.
- Do not chase high growth. Be careful not to chase the most growth oriented sectors of the market after such a strong start to the year. Near-term risk of higher interest rates is increasing, and these areas do tend to be interest rate sensitive. Value-style stocks are trading at well above-average valuation discounts to their growth counterparts despite the strong 2022 and have historically performed better in inflationary, higher interest rate environments. Energy and industrials look like particularly fertile ground to find investment opportunities.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by Bloomberg, FactSet, and LPL Financial, tracking # 1-05361149.
- US Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit, and market risk. Bonds are subject to market and interest rate risk if sold prior to maturity..
- The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.