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The stock market delivered a lackluster performance in February as jumpy investors hit the brakes after January’s big rally. The S&P 500 fell more than 2% in the month of February, trimming its year-to-date return to just 3.9%.
Wall Street was spooked by clashing U.S. economic data. Inflation reports showed that the rate of decline in inflation has flatlined, which suggests that the Federal Reserve’s crusade against high prices is far from over. At the same time, another strong jobs report made it clear the labor market is still very tight.
The Fed’s dilemma—how to solve the inflation problem without kneecapping the labor market and causing a recession—remains the central obsession for markets. There are more emotions about the potential for a recession than concrete data showing that one is imminent, and it seems that markets are feeling stuck between fear and greed.
“Income and spending are solid in early 2023, allaying fears that the US economy is on the verge of recession right now,” said Bill Adams, chief economist for Comerica Bank.
Meanwhile, fourth-quarter corporate earnings reports were mixed, with public companies still struggling with rising costs and lingering recession fears. High-profile companies just can’t stop laying off workers, while workers are still finding it easy to get jobs.
Inflation Hits Pause
In the latter half of 2022, America’s post-pandemic inflation hangover appeared to be gradually easing. Annualized price increases peaked in June, then slowly floated lower through December. But the January data released last month showed inflation has hit the pause button.
The January consumer price index (CPI) was +6.4%, higher than economists had expected and more or less flat with the December reading of +6.5%. The other big monthly inflation report, the personal consumption expenditures price index (PCE), actually rose on an annualized basis to 5.4% in January (from a seasonally adjusted 5.3% in December).
“Much of January’s slowing year-over-year CPI was due to the recent drop in prices of used cars, which surged during the pandemic and are now slowly coming back to trend,” said Adams. Energy and food are still seeing sustained high annual price gains.
Smaller Fed Rate Hikes on Tap
The Federal Reserve has been gradually reducing the size of its interest rate hikes, from 75 basis points (bps) in November, to 50 bps in December and 25 bps at the meeting that concluded on February 1.
Minutes from the most recent meeting indicated that Fed officials still believe more rate hikes will be needed to curb inflation. The minutes also showed officials see the U.S. labor market as “very tight, contributing to continuing upward pressures on wages and prices.”
The Labor Department reported the U.S. economy added 517,000 jobs in January, nearly three times the 187,000 jobs economists were expecting. In fact, the U.S. unemployment rate dropped to just 3.4% in January, its lowest level in more than 50 years.
Sam Millette, fixed income strategist for Commonwealth Financial Network, says stubborn inflation, elevated personal spending and a tight labor market will make life very difficult for the Fed over coming months.
“While we’ve seen signs that overall inflationary pressure may have peaked late last year, there is still a considerable amount of short term uncertainty when it comes to inflation and therefore monetary policy,” Millette says.
Markets expect additional 25 bps rate hikes at upcoming Fed meetings. Traders see a 75% chance the Fed will deliver another quarter-point increase at the March 21-22 meeting, which would put the federal funds rate target at 4.75% to 5.00%.
U.S. Recession Watch
It may be very difficult for the Fed to justify pausing interest rate hikes until the jobs market cools down and inflation resumes its decline.
The higher the rates rise, the greater the likelihood of economic fallout at some point down the line. This risk was reflected in “recession probability” indexes compiled by regional Federal Reserve banks. The New York Fed’s recession probability index reached its highest level in 40 years in February.
The ratio of U.S. job openings per unemployed person has risen to a near-record 1.9 and is well above its pre-pandemic level of 1.2. When a growing number of companies are forced to compete for a shrinking pool of qualified job candidates, it drives wages higher.
Higher wages are good news for workers, but they also contribute to inflation—hence the Fed’s big dilemma. Companies often pass rising labor costs on to customers by raising prices on products and services.
Then there’s the U.S. debt ceiling drama. The U.S. reached its current debt limit in January, but Treasury Secretary Janet Yellen has implemented a series of “extraordinary measures” that will allow the U.S. government to continue to borrow money in the short-term to meet its debt obligations.
In February, the nonpartisan Congressional Budget Office said the Treasury’s emergency measures to prevent a U.S. debt default will be exhausted sometime between July and September if Congress fails to raise the $31.4 trillion U.S. debt limit.
Any debt ceiling crackup could significantly damage the jobs market, worsen inflation and greatly increase the chances of a recession.
Earnings Slowdown
Fourth-quarter earnings season has been mixed, and analysts have a somewhat bleak outlook for the first half of 2023. S&P 500 companies have reported a 4.8% year-over-year decline in earnings in the fourth quarter. That would mark the first negative earnings growth rate for the S&P 500 since the third quarter of 2020.
The one exception to slumping corporate earnings is the energy sector, which has reported 58% earnings growth in the fourth quarter. The war in Ukraine and global commodity inflation sent energy prices soaring in 2022 and helped many oil and gas stocks generate record profits.
Unfortunately, analysts are anticipating negative overall earnings growth will continue in the first half of 2023. Analysts project S&P 500 earnings will drop 5.7% year-over-year in the first quarter and another 3.7% in the second quarter.
DataTrek co-founder Nicholas Colas says investors should prepare for at least three consecutive quarters of negative earnings growth.
“Even though U.S. and global economic growth is still in positive territory, the final quarter of 2022 was the start of an earnings recession that analysts expect will continue for two more quarters. Thus far the declines in earnings power are modest, which is why U.S. large-cap stocks remain relatively resilient,” says Colas.
How To Invest In March
February has typically been one of the worst months of the year for the U.S. stock market. Historically, the S&P 500 has performed better in March and April. Since 1928, the S&P 500 has averaged a 0.5% gain in March and a 1.4% gain in April.
“Investors had started the year on a positive note, hoping that the worst was behind us, but if inflation remains sticky—which is what we have been saying it will be since last year—then the market is going to continue to be volatile and this year’s gains remain in doubt,” says Chris Zaccarelli, chief investment officer for Independent Advisor Alliance.
Investors concerned about the U.S. economic outlook can take a defensive approach in March by reducing their exposure to stocks. One of the silver linings of the inflation crisis has been rising interest rates for high-yield savings accounts. Investors can currently earn more than 4.5% APY on certain high-yield savings accounts that are insured by the Federal Deposit Insurance Corporation (FDIC), making them essentially risk-free.
Value stocks have also historically outperformed growth stocks when interest rates are high. High interest rates have a negative impact on discounted cash flow valuations, which can hurt high-growth stocks. In the past year, the Vanguard Value ETF (VTV) has a total return loss of just 0.4%, while the Vanguard Growth ETF (VUG) has a total return loss of approximately 16%.
In addition, certain stock market sectors are considered more defensive than others because they generate relatively stable earnings and cash flows regardless of the economic cycle. Utility stocks, consumer staples stocks and healthcare stocks are typically considered defensive investments, and they may be relatively insulated in the event of a recession.