Sightline Weekly Market Update: The Federal Reserve is Between a Rock and a Hard Place
Last week, the much-anticipated inflation reading staggered the large-cap equity markets while the S&P 400 MidCap and small-cap Russell managed a modest gain. The growth stocks of the Nasdaq came under the most pressure falling 2.18% on the week, pushing the year-to-date performance to a negative 11.85%. Since late last year, the Nasdaq is down approximately 15% from the peak. The Dow Jones and the S&P 500 fared slightly better than the Nasdaq, with declines of 1% and 1.82%, respectively. The TSX gained 1.39% on the week as oil prices advanced 1.7%, closing at a recent high of $93.84. This week’s inflation data for Canada is expected to remain more subdued than south of the border. European markets all posted positive gains on the week supported by solid earnings. The pan-European STOXX 600 Index rallied 1.61%, with all the major European indices advancing on the week.
On the earnings front, FactSet reports 72% of the S&P 500 companies have reported earnings for the fourth quarter. Of those 77% reporting earnings surprises, which is above the five-year average of 76%, the aggregate surprise is coming in at 8.6%, in line with the five-year average. Compared to last year’s earnings, growth is up more than 45%, and Q4 is the fourth quarter reporting earnings growth of more than 30%. The extraordinary growth in earnings is attributed to the closing and re-opening of the economy due to the Covid-19 pandemic. All 11 sectors reported an increase on the revenue front, with 77% of the reporting companies reporting revenue surprises above estimates. Energy led the way with revenues up over 80% in Q4 on rising oil prices.1
On Thursday, the US Bureau of Labor Statistics reported CPI increased by 0.6% in January, exceeding Wall Street’s forecast of a 0.4% gain.2 The latest reading pushed the annual inflation rate to 7.5%, a 40-year high. The food component of the index rose 0.9% in January after a 0.5% increase in December. Energy increased by 0.9% in January after a similar rise in December. Even after a decline of 0.8% for gasoline in January, gasoline is up 40% for the year. However, fuel oil topped the list gaining 9.5% in January, pushing the year-to-date total to an increase of 46.5%. Ex food and energy, the CPI increased for January 0.6% for an annual rate of 6%.3
The other data point of significance in the week was the University of Michigan Survey of Consumers. The Consumer Sentiment Index fell 8.2% to 61.7 compared to 67.2 the previous month and 19.7% year-over-year decline. The latest reading is the lowest level in a decade. The survey of Current Economic Conditions fell 4.9% to 68.5 in the month and is down over 20% since a year ago. Expectations have also declined, dropping 10.5% to 57.4 and have declined 18.8% year-over-year. Surprisingly, the cohort with the largest decline in sentiment came from households with incomes of $100,000 or more, with their sentiment falling 16.7% and 27.5% from a year ago. Nearly half of those surveyed expected declines in their inflation-adjusted incomes one year out. The latest fall in sentiment is attributed to rising inflation, falling confidence in government economic policies, and the least favorable economic outlook in a decade. The newest sentiment readings could be interpreted as a sign of an impending downturn in consumer spending activity. 4
Jobless claims rounded out the week, with claims falling 16,000 from the previous week to 223,000. Continuing claims for all benefit programs increased 32,069 over the last week to 2,099,857. In 2021 in the same week, there were 20,242,844 filing for benefits.5
Last week’s continued rapid acceleration of inflation created a firestorm of speculation and debate surrounding the Federal Reserve policy response. The market had priced in five to six rate increases, but now speculation centers around whether five or six increases is enough and whether quarter-point increases are an appropriate response with inflation running at 40-year highs. From a historical perspective and the seriousness of the problem, John Williams, an economist who calculates an alternative rate of inflation using the official methodology pre-1980, has inflation running at just over 15%. The last time inflation was running at the current level was in 1982, when inflation hit 15%.6 To control inflation, Paul Volker, the Fed Chairman of the day, increased the Fed funds rate to almost 20% compared to today’s rate of 0.25%. The current Fed is in a box. The level of government debt is at historic peacetime levels, and an increase in interest rates will significantly impact the debt service costs. The frailty of the current economy may not be able to withstand higher rates after decades of low rates. Higher inflation, long thought of as a by-product of liquidity, this time may be from the supply side brought on by shutting down economic activity to combat Covid.
Anticipated higher rates are impacting valuations of companies not expected to generate earnings for years to come. The decline in the Nasdaq indicates the valuation adjustment resulting from higher rates used in the discount models of analysts. There is no doubt that we are heading for a period of increased volatility for equity and fixed income markets going into 2023.
Warren Gerow is an independent investment wealth consultant to Sightline Wealth Management.
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