U.S. major indices were mixed this week, as investors considered some healthy growth and profit signals against worries that inflation pressures will continue for the foreseeable future. Fears that the Federal Reserve would raise short-term interest rates more than previously expected caused U.S. Treasury yields to increase. Treasuries were weaker along with curve flattening, as the 2-year yield rose to its highest level since November before lowering. The 2-year to 10-year yield spread had its deepest inversion since the early 1980s. Sector performance was mixed, as consumer discretionary and consumer staples outperformed the most while energy and real estate underperformed the most. Oil is priced in U.S. dollars results pressure on demand when the dollar appreciates. The dollar index rose for a third straight week.
This week’s January inflation release illustrates that the Fed will hike rates again. January’s report shows that inflation is very gradually declining, but several analysts expect that downward trend will accelerate. January’s Consumer Price Index (CPI) rose by 0.50% month over month and by 6.4% year over year. The headline gain was driven by a 2% month over month rebound in energy prices. Core CPI (excluding food and energy) increased by 0.4% month over month in January and by 5.6% year over year. Core services prices increased at a slower rate due to a smaller increase in rent. Shelter costs are the largest driver of the core CPI basket.
Retail sales rose by 3% month over month in January, significantly more than expected. This sharp rise is due milder winter in the Northeast, and the tightness of the labor market that shows the economy remains resilient for the time being. In January, there were increases in vehicle sales, furniture food and drink services sales. These increases in sales reflect that consumption remains strong and according to analysts it will be stronger than expected in the first quarter. This week’s retail sales data and inflation data are supportive of the Fed’s view that additional rate hikes are needed to cool the economy and bring inflation down to 2%.
Bonds generated negative returns for the week as economic data seemed to confirm recent hawkish comments from Fed officials that there was more work to do to tame inflation. Cleveland Fed president Mester stated last week she said, “ I saw a compelling economic case for a 50 basis-point increase” at the Fed's most recent meeting, when it decided to hike by 25bp. Likewise, St Louis Fed President Bullard said he wouldn’t rule out a 50bp hike in March, stating “it will be a long battle against inflation.” The Fed’s terminal rate is now forecast to be close to 6%.
Analysts view remains that a mild economic downturn or a growth slowdown, combined with a modest rise in unemployment, will likely appear in the next couple of quarters. Leading economic indicators, the inverted yield curve and business activity surveys, are pointing to lower consumer and business demand ahead. The Fed's rate hikes probably have not been fully filtered through the economy and will affect it sometime later.
The earnings performance of S&P 500 companies during the Q4 earnings season continues to be below average. Overall, 82% of the companies in the S&P 500 have reported results for Q4 2022 to date. Of these companies, 68% have reported EPS above estimates, but below the 5-year average of 77%, and below the 10-year average of 73%. The revenue performance of S&P 500 companies during the Q4 earning season has been more positive than the earnings performance. Overall, 65% of S&P 500 companies have reported revenues above estimates, which is below the 5-year average of 69%, but above the 10-year average of 63%. EPS fell by 1% year/year and by 5% excluding Energy.
Looking ahead analysts expect earnings declines for the first half of 2023, but earnings growth for the second half of 2023. According to analysts’ estimates, the forward 12-month P/E ratio is 18.0, which is below the 5-year average of 18.5 but above the 10-year average of 17.2.
Equity and bond markets will underperform due to increased volatility until there’s a substantial and consistent decrease in inflation and the duration of higher rates is more certain as a “data-dependent” Fed focuses on the cumulative effects of rate hikes. We remain defensive in our positioning. In the coming months we think as inflation pressures are easing, the direction for markets will be higher but the road ahead of us will be bumpy. Investors can dollar-cost-average to take advantage of a likely uptick in volatility and use any potential correction as an opportunity to position for a more sustainable rebound ahead. Within equities, we continue to favor developed markets (US / Europe), certain Large Cap equities provide an attractive blend of quality, yield, and growth at a reasonable value even if earnings expectations continue to deteriorate. For fixed income, we remain defensive in our credit positioning, with at benchmark duration, and higher in credit quality. We expect credit spreads to remain elevated to account for recession risks.