Thursday, February 2, 2023
HomeBusinessMixed Messages From Markets And The Fed Revolve Around Inflation And Recession

Mixed Messages From Markets And The Fed Revolve Around Inflation And Recession

At first blush, stocks and bonds liked the November consumer inflation (CPI) reading on Tuesday, but by the end of the day, the S&P 500 closed up less than 1% after being almost 3% higher in the morning. The 10-year U.S. Treasury yield plunged to 3.4% at one point but rebounded to 3.5% by the close after ending at 3.6% on Monday. The good news was that headline inflation fell to 7.1% year-over-year, down from 7.7% the previous month and below expectations of 7.3%. The less supportive part was the measure of sticky inflation rising to 6.6% from 6.5% year-over-year, meaning that the components of inflation that tend to move slowly are still rising.

In addition, services inflation has continued to rise and hit a new 2022 high of 6.8% year-over-year. Services pricing continues to be supported by a resilient labor market and rapid wage growth. Plus, consumer preferences have shifted back to demanding more services versus goods.

As expected, the Federal Reserve (Fed) delivered a 50 basis point (0.50%) hike at the meeting on Wednesday. With the outcome of the meeting holding little suspense, the focus was on Chair Powell’s press conference, the summary of economic projections (SEP) forecasts, and especially the dot plot. The median economic predictions from the committee provide insight into the expected policy path and outcomes. GDP growth estimates were slashed to 0.5% from 1.2%, which implies slowing growth but no recession. Notably, the Fed expects the unemployment rate to rise to 4.6% in 2023 from 3.7%. This estimate leads to a conflict because this magnitude of an increase in the unemployment rate has typically led to a recession, according to the Sahm Rule. In addition, the Fed expects to increase the short-term interest rate to 5.1% in 2023 to combat inflation, with no expectation of a rate cut.

Markets have a very different expectation of what the Fed will actually do in 2023. Financial markets are pricing in a non-trivial probability of a rate cut in 2023. Despite the increased expectations for rate hikes released by the Fed, the one-year forward Fed funds rate fell on the week.

One reason for the lower expected short-term interest rate by markets is that it is typically wise to expect a recession in 2023 based on the yield curve inversions. In addition, the Bloomberg Economics’ recession model has a 100% probability of a recession occurring over the next 12 to 24 months. Indeed, the yield curve and the Bloomberg models are fallible, but the markets are discounting mechanisms, and the odds favor recession despite a good growth profile this quarter.

Markets also expect inflation to moderate reasonably quickly, with the market-based measures of inflation expectations falling to essentially the lows of 2022. This decline in inflation expectations is likely directly connected to the high probability of a coming recession. In most recessions, inflation and yields tend to decline, but as discussed previously, this is not always the case.

While stocks generally have been poor performers over the last two weeks, with the S&P 500 declining by over 5%, bank stocks have been even worse. The KBW Bank index has fallen by over 8% during the same period. Bank underperformance was likely driven by rising expectations of a rate cut in 2023 due to a recession which typically leads to lower loan growth and higher loan losses at banks.

Regardless of whether the Fed or markets are correct in their respective expectations, the macroeconomic focus should continue to move stocks as a group and uncover some opportunities for long-term investors to upgrade portfolios. Seeking out quality, valuation, and dividend growth should serve investors well with less risk of permanent capital loss during the likely upcoming recession. U.S. small-cap stocks are also worthy of consideration as they sell at a significant discount to large companies but should also be more volatile.

Abdullah Anaman
Abdullah Anaman
I am a highly competent IT professional with a proven track record in designing websites, building apps etc. I have strong technical skills as well as excellent interpersonal skills, enabling me to interact with a wide range of clients.


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