After enjoying solid gains through the end of January and early February, stocks pulled back last week amid a rise in yields and a stronger dollar as there was a hawkish shift in Fed policy expectations, suggests Jim Woods, editor of The Deep Woods.
The S&P 500 (SPX) fell 1.11% on the week and is up 6.54% YTD. At the start of last week, stocks traded with a heavy tone as the shockingly strong January jobs report, and its potential implications for Fed policy, continued to be assessed while geopolitical tensions rose given the Chinese surveillance balloon debacle. The Fed’s Bostic reiterated that he anticipates two rate hikes this year, which kept pressure on stocks. The S&P 500 closed down 0.61%.
Trading was quiet and choppy ahead of Powell’s interview with Bloomberg, but that changed in a big way once he began to speak. Stocks initially rallied as Powell noted disinflationary trends are taking hold, but a huge tail in the Treasury’s 3-Year Note auction saw the major indexes fall to session lows. Powell later was quoted saying, “it may be different this time” to which traders flipped into risk-on mode and the S&P roared back to close higher by 1.29%.
Stocks gave back some of Tuesday’s gains on Wednesday amid more consistently hawkish commentary from regional Fed presidents as well as an unexpected increase in the Manheim Used Vehicle Index, which rekindled worries about 1970’s-style “stop-start inflation” trends. A strong 10-Year Treasury Note auction helped ease the pain but the S&P 500 still lost 1.11%.
On Thursday, stocks gapped higher at the open after German CPI undershot estimates, easing some of the uncertainty about inflation trends while solid earnings from DIS bolstered optimism about the health of the U.S. consumer. But the hawkish Fed speak continued with Barkin and a report from the AAII that sentiment among retail investors (typically viewed as a contrarian indicator) had turned bullish for the first time in 10 months. The rollercoaster of Treasury auctions continued with a very soft 30-Year auction in the early afternoon and that saw equities fall to new lows into the close. The S&P 500 declined 0.88%.
Stocks gapped lower at the open on Friday as Russia announced a planned oil production cut which sent both oil prices and yields higher. The former raised concerns about inflation while the latter was an indication of more hawkish money flows. The S&P 500 closed a gap back to Thursday’s close before turning back lower as traders digested an uptick in consumer inflation expectations within the University of Michigan’s Consumer Sentiment report.
The odds that the fed funds rate is above 5% at yearend notably jumped from just 10% coming into the week to over 45% Friday. Stocks were able to hold the morning lows and churned higher into the afternoon with the S&P 500 gaining a modest 0.22%.
Data Really Is the Key to This Market
Stocks declined last week thanks to signs of stickier-than-expected inflation and hawkish commentary from regional Fed presidents. But considering the surge in bond yields over the past week, the declines in stocks could have been a lot worse.
Consider: Markets have dramatically altered their Fed rate hike expectations over the past six trading days, as terminal fed funds expectations are now over 5% (up more than 25 basis points from before the jobs report) while year-end fed funds is just under 5% (up basically 50 basis points from the lows after Powell’s presser).
In 2022, a move of that size would have caused a sharp, intense pullback in stocks (like we saw in June and late August). But it caused just a mild pullback in stocks last week and that resiliency must be respected. As far as “why” stocks are resilient, there are three main factors.
First, the market thinks the end of Fed rate hikes are in sight, with one or two more hikes coming before the pause. Second, economic growth remains strong, so it’s emboldened markets to hope the economy can withstand rates at or near current levels (i.e. the no-landing scenario). Third, the market believes inflation will continue to decline (consistent disinflation).
So, in order for stocks to stay resilient, these three assumptions need to remain in place, otherwise concerns about a hard landing will resurface, and stocks will drop. Specifically, that means this week markets need to see, in order of importance:
1) Stable price data starting with tomorrow’s CPI report and followed by the price indices in the Empire and Philly Fed manufacturing surveys. There is a risk inflation bounces back given other data, and if it’s a decent bounce it will likely create more volatility.
2) Stable economic growth, via Retail Sales and Empire/Philly Fed surveys. Again, the market is resilient because it thinks the economy can withstand rates at current levels and the data this week needs to reinforce that message.
3) Not-hawkish Fed speak from Fed leadership. Regional presidents (Bullard, Kashkari, Bostic, etc.) can sound hawkish but they aren’t in charge. However, if Brainard of Powell hint that rates need to go higher than 5.125%, that will be a fresh headwind.
The macro backdrop has positively changed from 2022 and that’s reflected in the market’s resilience in 2023. But that resilient nature is based off these key assumptions and they need to be reinforced for stocks to solidify the YTD gains. If the data implies one (or more) of these assumptions are false, then a 5% pullback (or more) shouldn’t be a surprise.
I appreciate the recent outperformance of growth/value but until there’s more clarity on just how likely each of these market assumptions are, I prefer to maintain tactical overweights towards value, defensive sectors and minimum volatility ETFs, simply because I believe the downside in this market on disappointment remains larger than the upside on any surprises.
Need-to-Know Economic Data
There were only three notable economic reports last week but two of the three hinted that inflation pressures may be mildly bouncing, while the third pointed to a still very tight labor market, and these reports contributed to the weakness in stocks last week.
Starting with the inflation data, there have been some anecdotal signs that inflation pressures may be bouncing near term (specifically the European CPIs and the price indices in the ISM PMIs) and there was more evidence of that last week as the Manheim Used Vehicle Value Index rose for the first time in months, while the University of Michigan Inflation Expectations Survey saw a small increase in one-year inflation expectations to 4.2% from 3.9% while the five-year expectations remained at 2.9% (where they’ve been for the past three months).
Neither of those numbers imply inflation is making a strong comeback, but they do hint that the rapid disinflation we’ve seen over the past several months may be easing, and while inflation is still clearly declining, it may be entering more of a “stair step” decline phase than a straight line down, and that realization may result in some disappointment in markets, if it’s proven out.
The other notable economic report was weekly jobless claims, which rose slightly to 196k vs. (E) 192k, but that number remains far, far too low to imply there’s balance in the labor market. Last week’s data hinted at the no-landing scenario as anecdotal inflation metrics were firm while jobless claims remained low.
We said in last Friday’s report that economic growth data and inflation had become even more important than before, because solid growth data and disinflation have allowed stocks to (mostly) weather a sharp and sudden spike in bond yields, and the inflation and growth data will need to continue to decline and stay resilient (relatively speaking) to continue to support stocks.
That makes tomorrow’s CPI report again the most important economic report of the month, and none of us should be surprised if this number is hotter than expected. There have been several anecdotal inflation indicators including the Manheim Used Vehicle Value Index and the price indices in the ISM Manufacturing and Services PMI that implied price pressures may have bounced back after several months of disinflation, and that may well show up in tomorrow’s CPI report. Hopefully that isn’t the case, and even if it happens it doesn’t mean that inflation isn’t still declining—it is, just not in a straight line. Markets need an inflation number that meets or comes under expectations (especially for Core CPI) otherwise pressure on stocks will increase.
Beyond CPI, we get several important growth updates this week, starting with the first look at February economic data via the Empire Manufacturing Index (Wednesday) and Philly Fed (Thursday). Markets will want to see stability in this data especially given the rise in bond yields. Additionally, declines in the price indices will be welcomed, while any increase in prices will only further fears that the pace of disinflation is easing.
The next most important growth update comes via February Retail Sales (out Wednesday). Consumer spending powers the U.S. economy but it also supports services inflation. However, the support it gives for the economy far outweighs any upward pressure on inflation, so the market will want to see stability in the data. Point being, an ugly retail sales report likely won’t be good for stocks because it might make the Fed less hawkish (it probably won’t regardless). Instead, it’ll just increase the chances of an economic hard landing, and as such likely increase the headwinds on stocks amidst higher rates.
Other notable economic data this week includes Industrial Production and Capacity Utilization (which will give us hard data on the state of manufacturing) and weekly jobless claims (which need to trend higher in the coming weeks).
Bottom line, even despite the small pullback from the recent highs, stocks have withstood a sharp jump in yields and increase in rate hike expectations very well. For that to continue we’ll need to see inflation not bounce back and economic growth remain resilient. If the data this week shows that, then stocks can stay resilient despite higher yields. If it doesn’t, then we should not be surprised if the S&P 500 trades below 4,000.
Need-to-Know from Commodities, Currencies and Bonds
Commodity markets traded with a mixed tone last week as energy outperformed, posting solid gains amid hopes for a soft landing and bullish production news out of Russia late in the week. The metals were lower thanks to a stronger dollar and hawkish money flows sending interest rates higher. The commodity ETF, DBC, rallied 3.05% on the week.
The dollar rallied moderately following Powell’s press conference of two weeks ago, but since then it’s rallied solidly thanks to strong data and surprisingly firm anecdotal inflation readings that has challenged the idea that the Fed is the last-hawkish major central bank. The repricing of that expectation has helped the dollar back into the low-to-mid 100 range.
Turning to Treasuries, yields continued the rally that started following the February jobs report, as the 2-year Treasury yield rose 9 basis points while the 10-year yield gained 10 basis points. Momentum, hawkish utterings about more rate hikes from Fed officials, and anecdotally sticky readings on inflation contributed to the rise in yields, as the 2 year now is not far from the 2022 high (meaning rate-hike expectations are close to as high as they’ve been since the hiking cycle began).
Looking at 10s-2s, it closed the week at -78 basis point after briefly touching lows of -82, essentially matching the lows for 2022 as the bounce in rates has only strengthened the bond market’s signal that the Fed is already too tight, rates are already too high, and additional hikes will only make the looming economic contraction worse.
So far, these warning messages from the bond market haven’t been confirmed by the data, but of the two major slowdowns I’ve been through in my career (2000-2003 and 2007-2010) the one thing they both had in common is they took longer to arrive than people thought reasonable, and it’s those experiences that has me listening to the bond market again, and wary of a slowdown.
