What’s next for stocks as investors realize Fed’s inflation fight won’t end soon

“The idea that equity markets would experience a strong upside surge while the Fed was still hiking and the market was underestimating what Fed was going to do” had looked “untenable,” said Lauren Goodwin, economist and portfolio strategist at New York Life Investments, in a phone interview.

Market participants have come round to the Fed’s way of thinking. At the end of January, fed-funds futures reflected expectations the Fed’s benchmark interest rate would peak below 5% despite the central bank’s own forecast for a peak in the 5% to 5.25% range. Moreover, the market was forecasting the Fed would deliver more than one cut by year-end.

That view began to shift after the release of a January jobs report on Feb. 3 that showed the U.S. economy added a much larger-than-expected 517,000 jobs and showed a drop in the unemployment rate to 3.4% — its lowest since 1969. Throw in hotter-than-expected January consumer and producer price index readings and Friday’s bounce in the core personal consumption expenditures price index, the Fed’s favored inflation measure, and the market’s outlook on rates looks much different.

Participants now see the Fed raising rates above 5% and holding them there through at least year end. The question now is whether the Fed will bump up its forecast of where it expects rates to peak at its next policy meeting in March.

That’s translated in a backup in Treasury yields and a pullback by stocks, with the S&P 500 down around 5% from its 2023 high set on Feb. 2, leaving it up 3.4% in the year to date through Friday.

It isn’t just that investors are learning to live with the Fed’s expectation for rates, it’s that investors are realizing that bringing down inflation will be a “bumpy” process, said Michael Arone, chief investment strategist for the SPDR business at State Street Global Advisors, in a phone interview. After all, he noted, it took former Fed Chairman Paul Volcker two recessions in the early 1980s to finally crush a bout of runaway inflation.

The run to the S&P 500’s Feb. 2 high was led by what some analysts derisively called a “dash for trash.” Last year’s biggest losers, including highly speculative shares of companies with no earnings, were among the leaders on the way back up. Those stocks suffered particularly last year as the Fed’s aggressive cadence of rate hikes sent Treasury yields up sharply. Higher bond yields make it harder to justify holding stocks whose valuations are based on earnings and cash flow projected far into the future.

Inflation readings this month have all been hotter than expected, resulting in the “reversal of everything that was working” previously, Arone noted. The 10-year Treasury yield had fallen, the dollar was weakening, which means that highly speculative, volatile stocks are giving back leadership to companies that benefit from rising rates and inflation, he said.

The energy sector was the sole winner among the S&P 500’s 11 sectors in the past week, while materials and consumer staples outperformed.

The Dow Jones Industrial Average
DJIA,
-1.02%
dropped 3% last week, leaving the blue-chip gauge down 1% so far in 2023, while the S&P 500
SPX,
-1.05%
slid 2.7% and the tech-heavy Nasdaq Composite
COMP,
-1.69%
dropped 1.7%. The Nasdaq trimmed its year-to-date gain to 8.9%.

Goodwin sees scope for stocks to fall another 10% to 15% as the economy slides toward recession. She said that while earnings results showed bottom line results continue to hold up relatively well for tech and consumer discretionary sectors, top line revenues are decelerating — a troubling mismatch. Outside of the pandemic winners, companies are struggling to maintain profit margins, she noted.

Indeed, margin trouble could be the next big worry, Arone said.

Net margins are below the five-year average because businesses have reached a limit when it comes to passing on price increases customers.

“My view is this will remain a headwind for the outlook for stocks and one that’s a bit under the radar,” he said. That might explain why sectors that still enjoy high margins or are able to increase margins — such as the aforementioned energy and industrials — were outperforming the market at the end of the past week.