A series of upside inflation and growth news surprised analysts

In one sentence last week’s market performance and economic news it could very well be described as “This is your captain speaking: we’re experiencing some turbulence”. A series of upside inflation and growth news surprised analysts and investors. Stocks fell sharply following worrisome signs that inflation might have reversed course and accelerated again as the year began. The S&P 500 and Nasdaq falling for three consecutive weeks and staging the worst weekly performance since the beginning of December. Growth and value performed in tandem, all sectors ending the week lower except for energy. The dollar index was higher for a fourth straight week, staging the largest weekly gain since September. The Cboe Volatility Index (VIX), Wall Street’s so-called “fear index,” jumped but remained a bit below its mid-December levels. Treasuries were weaker while the yield curve steepened. A sell-off in U.S. Treasuries pushed the yield on the benchmark 10-year U.S. Treasury note near 4.00% for the first time since mid-November. Investment-grade corporate bonds traded lower after some major retailers reported ”light” earnings showing concerns about the health of the U.S. consumer. The U.S. economy grew at a slightly slower pace in the fourth quarter of 2022 than originally estimated, according to a revised government release on Thursday. GDP expanded at an annualized rate of 2.7% in the latest quarter, down from an initial 2.9% estimate released a month earlier. The downward revision was attributed in part to slower consumer spending than initial data had shown. January’s personal income, inflation, and spending data show that inflation is too strong for the Fed. These data show that inflation isn’t falling quickly enough. Personal income was also stronger than expected in January, as wage and salary income rose the most since July. Investors expect more rate hikes. According to CME Group data, futures markets are pricing in a 27% chance of a 0.50% hike in the federal funds target rate at the upcoming March policy meeting, with approximately a 38% likelihood that the terminal rate would reach a target range of 5.50% to 5.75% or higher. This week’s jobless claims data shows that the labor market remains tight, meaning the economy is still too strong for the Federal Reserve, and will continue to hike rates further to slow inflation. Despite several layoffs in the United States, initial jobless claims fell to 192,000,000 the last week that ended last Saturday, at very low level, keeping initial jobless claims below 200,000 since the beginning of 2023. As economic growth slows further, we expect jobless claims will rise, although not as quickly as they did during other economic downturns. The Fed continues to monitor the labor market closely. Due to higher interest rates, the housing market is the one of the few sectors of the US economy that continues to show signs of weakness, but the speed of deterioration isn’t as severe as analysts have anticipated last year. This week, existing home sales fell by 0.7% month over month in January. Sales declined for a 12th straight month, down by 37% from their highs a year ago. It is expecting existing home sales to fall further as economic growth slows, mortgage rates remain high and credit conditions continue to tighten, thus keeping potential buyers on the sidelines. Equity and bond markets will suffer due to elevated volatility until there’s a substantial and consistent decrease in inflation and the duration of higher rates is more certain as markets become comfortable with a “data-dependent” Fed that’s now focused on the cumulative effects of rate hikes. As we have previously mentioned in our Weekly Reviews, we remain defensive in our positioning, and we’d look for opportunities to upgrade portfolios during market weakness. Within equities, we continue to favor U.S. Large Cap exposure, since China’s evolving COVID policies continue to weigh on manufacturing and growth. We’ve recently become more constructive on European equities, as the energy recession wasn’t as severe as anticipated. In the United States, large cap equities provide an attractive blend of quality, yield, and growth at a reasonable value, even though earnings are expected to deteriorate further during the first quarter of 2023. In terms of fixed income allocations, this environment should favor longer duration, steeper yield curves and more prudent credit selection. We remain defensive with a benchmark duration, and higher in credit quality. We expect credit spreads to leak wider to account for slowing growth and recession risks.