U.S. equities were higher this week, with all the major indexes posting solid gains for the week while the S&P 500 ended a three consecutive weeks decline. All sectors ended the week higher except for utilities and consumer staples. Treasuries were mostly weaker with the curve flattening. The 10-Year U.S. Treasury yield broke through the 4% level for the first time since November 2022, but closed the week slightly below 4%. Treasury rates declined, as the yield on the 2-year note was 7 basis points (bps) lower at 4.86%, the yield on the 10-year note decreased 11 bps to 3.97%, and the 30-year bond rate fell 13 bps to 3.89%. The dollar index was weaker, falling 0.7% for the week to 104.50., breaking four straight weeks of gains. Crude oil prices were higher, 4.6% this week to $79.79/bbl and natural gas futures surged 28.7% to $3.14/mmbtu., and gold rallied. The positive momentum was triggered from Atlanta Federal Reserve President Raphael Bostic speech at a Racial Inequality Conference in Dallas, stating that “he still supported only a quarter-point rate hike at the Fed’s upcoming policy meeting despite the previous week’s hot inflation data”. He also stated that the "Fed could be in position to pause by mid to late summer."
This week’s economic data releases show that the economy is mixed, with weakness in manufacturing but strength in services. The Institute for Supply Management (ISM) Services Index retreated but remained in expansion territory in February to 55.01, compared to the Bloomberg consensus estimate of a dip to 54.5. The key services sector index continued to grow as new orders expanded. The employment index fell into contraction territory in February, indicating that manufacturing activity remains weak. The prices paid index, a proxy for the prices paid for a good or service by consumers rebounded. Economists are concern that the recent resilience of the economy has added to inflationary pressures despite the increase of rates. The ISM manufacturing production subindex fell to its lowest level since May 2020, suggesting that manufacturing is falling at a 7% yearly rate, according to Capital Economics. Additionally, the employment index fell back into contraction territory in February, further indicating that manufacturing activity remains weak. There were no signs that inflationary pressures increased, as the prices paid balance fell to a two-year low and the supplier deliveries index fell to its lowest level since mid-2009. While there was mixed survey data this week for manufacturing and services, the Federal Reserve (the Fed) remains focused on the inflation and on services that are still in expansionary territory, the Fed will further raise rates.
The Conference Board’s Consumer Confidence Survey fell to 102.9 in February from 106 the prior month, falling for the second straight month. According to analysts this reading shows evidence that slowing economic growth has weighed on consumer sentiment and suggests that demand will further slow in 2023. Although sentiment on labor market conditions improved and inflation expectations declined, consumers became less optimistic overall about economic growth over the next six months. This week, the rates market expectations for the terminal rate (the level at which the Fed is expected to stop raising interest rates) were pushed higher, as select economic indicators came in stronger than expected. Our view is that the terminal rate will hit 5%+ in the first half of the year. We maintain our view that the Fed will raise rates later this month, likely by 25 basis points, and keep rates higher for longer as inflation remains stickier than expected and the labor market remains tight. We expect the Fed to keep rates high until the labor market moderates and inflation moves closer to 2 - 3% goal.
Stocks in Europe were mostly higher. The Eurozone February Services PMI was unexpectedly revised slightly lower than initially estimated, while the U.K. Services PMI for last month was surprisingly adjusted to a higher. Uncertainty regarding how aggressive the Fed in the U.S., the European Central Bank, and the Bank of England will need to remain to try to combat the persistent inflation pressures continued to foster volatility in the markets. The euro and the British pound rose versus the U.S. dollar, while bond yields in the Eurozone and in the U.K. were lower.
Nearly all companies in the S&P 500 have reported Q4 2022 earning. According to reports, earnings recession is in place following the second consecutive quarter of negative growth. Fourth-quarter earnings declined by 2.3% to approximately $54.30, slightly exceeding analyst expectations. 64% of companies reporting beat expectations, also the lowest total in at least three years. Sales continued to increase, but companies found difficult to pass prices increases to consumers at the same pace as their cost inputs increased. As a result, the market severely punished the companies that missed earnings expectations, and investors were focused on management guidance toward cost reductions and financial expectation for 1Q 2023. During the months of January and February, analysts lowered EPS estimates for the first quarter by a larger margin than average. The Q1 bottom-up EPS estimate decreased by 5.7% (to $51.13 from $54.20) At the sector level, 10 of the 11 sectors experienced a decrease in their bottom-up EPS estimate for Q1 led by the Materials (-12.6%), Health Care (-8.6%), Consumer Discretionary (-8.5%), and Industrials (-8.2%) sectors. On the other hand, Utilities (+3.1%) was the only sector that recorded an increase in its bottom-up EPS estimate for Q1 2023 during this period of January and February.
Equity and bond markets will suffer experience elevated volatility until there’s a meaningful and consistent decrease in inflation, and the duration of higher rates will be more certain as markets become comfortable with a “data-dependent” Fed. 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, we remain 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 and yield. For fixed income, we remain defensive in our credit positioning, with at benchmark duration, and higher in credit quality. We expect credit spreads will leak wider to account for slowing growth and recession risks.