Market Perspective: Searching for Spring
The transition between winter and spring is often contradictory. Green shoots push through snowdrifts, while spring-like warm days revert to cold nights. The economy is in a similar transition, as central banks' efforts to chill inflation face new signs of economic growth.
The big question, of course, is whether the Federal Reserve and other central banks will find a way to subdue inflation without causing a recession. As with the weather, though, the signs are frustratingly muddled. Corporate earnings, for example, have weakened, while other evidence suggests global manufacturing activity is actually strengthening. At the same time, longer-term Treasury yields have risen as the Fed has signaled it's not done raising interest rates just yet.
The absence of clarity can be unsettling. Here's how we see things shaping up.
U.S. stocks and economy: Mixed signals
Two measures from the labor market underscore this contradictory moment. Wage growth is slowing but remains fairly high. However, whereas growth in average hourly earnings—a comparatively noisy measure of workers' gross pay—has slowed relatively quickly, the Atlanta Fed's Wage Growth Tracker—which measures the median percent change in workers' hourly wages—hasn't moved as much. This presents a problem for the Fed, because such "sticky" wage growth could pose inflationary risks. If signs of further weakening don't appear, the Fed may decide to push short-term interest rates even higher.
Median wage growth has remained "sticky" even as average hourly earnings declined
Source: Charles Schwab, Bloomberg, as of 1/31/2023.
Atlanta Fed's Wage Growth Tracker is a measure of the nominal wage growth of individuals.
Any further tightening in policy might compound pressure building from a weaker corporate earnings backdrop. The share of companies in the S&P 500® Index reporting quarterly earnings above analysts' average estimates—known as the "beat rate"—has fallen in the reporting season for the fourth quarter of 2022. Not only that, but the companies that have beat estimates are doing so by the smallest margins since the 2007-2008 financial crisis.
Corporate earnings are not beating expectations as much as they used to
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 4Q2022.
Right y-axis truncated for visual purposes. Past performance is no guarantee of future results.
We think profit margins are likely to deteriorate further, which could pose a risk to the stock market this year. For that reason, we suggest investors who actively choose stocks focus on companies that have maintained—and still expect—strong profit margins.
Fixed income: Is the bond bear back?
Treasury yields have rebounded from their lows in recent weeks because the message from Fed officials is clear: "We're not done hiking rates. We will keep at it until inflation comes down."
The Fed's messaging combined with stronger-than-expected labor market data have renewed concerns that a bond bear market, with falling prices and rising yields, may be coming. We don't think that's likely. Here's why:
1. The Fed has allowed the yield curve to remain inverted, with longer-term yields below short-term yields. In past cycles, intermediate- and long-term bond yields have tended to stay low or keep falling until the Fed is near the end of its rate-hiking cycle—and bottom out at the onset of recession. Each recession is different, but the historical pattern has been consistent.
Where does that leave us now? Estimates of the terminal rate for interest rates are rising, while the Fed's rate hikes continue to push the yield curve to more steeply inverted levels. As a result, an inverted yield curve is likely to be a key feature of the Treasury market in 2023.
The two-year/10-year Treasury yield curve is inverted
Source: Bloomberg, daily data as of 2/13/2023.
Market Matrix US Sell 2 Year & Buy 10 Year Bond Yield Spread (USCY2Y10 INDEX). The rates are composed of Market Matrix U.S. Generic spread rates (USYC2Y10). This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100. Gray bars represent recessions. Past performance is no guarantee of future results.
There are two ways that the Fed could push long-term yields higher—either by abandoning its inflation-fighting target or by changing its quantitative tightening plans to include outright sales of bonds. We don't see either one happening. Nor does it appear that the Fed is targeting a level of long-term rates. The central bank seems fine with the curve remaining inverted.
2. Inflation has been declining, and inflation expectations are moderate. The Fed has recently indicated concern that inflation in the service sector (excluding housing) is stubbornly high. However, weakening consumer spending suggests price growth will continue to slow.
Inflation appears to have peaked
Source: U.S. Consumer Price Index Topline Contributions. Monthly data as of 1/31/2023.
Headline inflation reflects price changes to a basket of goods that includes commodities like food and energy. Core inflation excludes food and energy, whose prices tend to be volatile.
It may take some time for inflation to fall further, but we would need to see stronger demand for inflation to start moving higher again. With the trend in personal consumption expenditures declining and consumer credit growth slowing, we don't see another demand-driven bout of inflation.
Personal consumption spending has slowed
Source: Bloomberg. Monthly data as of 12/31/2022.
US Personal Consumption Expenditures Chained 2012 Dollars MoM SA. (PCE CHNC Index).
Meanwhile, market- and survey-based indicators suggest inflation expectations remain well anchored. Treasury Inflation-Protected (TIPS) breakeven levels are hovering in the 2% to 2.5% region, while the University of Michigan survey shows consumers see inflation averaging less than 3% in five to 10 years.
Consumers expect inflation of less than 3% over the next five-10 years
Source: Bloomberg. Monthly data as of 2/28/2023.
Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data. University of Michigan 1-year inflation expectations (CONSEXP Index) and 5-10 year inflation expectations (CONSP5MD Index).
3. Credit standards have tightened. Banks have made it harder and more expensive for consumers and businesses to obtain financing. The Federal Reserve's Senior Loan Officer quarterly opinion survey has shown significant tightening in both consumer and business lending since mid-2021.
Lending standards have tightened since 2021
Source: Federal Reserve, January 2023.
Senior Loan Officer Opinion Survey on Bank Lending Practices, January 2023. Net percentage of domestic respondents tightening standards for commercial and industrial loans.
Not surprisingly, consumer credit growth is slowing. With rates for mortgages, credit cards, and auto loans rising, the Fed's tightening policy is on track to slow consumption.
Consumer credit growth has slowed
Source: Federal Reserve, monthly data as of 12/31/2022.
Consumer Credit Total Net Monthly Change (CICTOT Index).
After a steep drop in intermediate- to long-term bond yields over the past few months, the recent rebound wasn't too surprising. Short-term yields are likely to continue rising over the next few months as the Fed keeps hiking the federal funds rate, its benchmark lending rate. However, we don't see 10-year Treasury yields moving to new highs above 4.35% in this rate-hike cycle.
Global stocks and economy: Green shoots?
The global economy, meanwhile, may have hit an inflection point amid signs manufacturing activity is crawling from its trough.
Global manufacturing has lagged in the post-pandemic era as inventory shortages turned to gluts last year, even as global demand for services (like travel and entertainment) boomed. In fact, according to purchasing managers' index (PMI) surveys of manufacturing business leaders, global exports of manufactured goods, and revenues of manufacturing firms, factory output actually fell into a recession at the end of last summer.
Now, however, signs have started to emerge that manufacturing may be bouncing back as surplus inventories are drawn down. Indeed, activity in leading industrial-driven economies like China and Germany is picking up, with the China PMI and German Ifo Business Climate Index both having recovered from lows reached in September-October 2022. Globally, manufacturing output is still weak, but forward-looking expectations and components such as new-orders-to-inventory ratios may be signaling the start of a rebound.
Based on new-orders-to-inventory ratios, manufacturing may be poised to rebound
Source: Charles Schwab, S&P Global, Bloomberg data as of 2/9/2023.
Growth in manufacturing would be a good sign for the global economy. Comments by global business leaders during the earnings season suggest healthy demand in China could help draw down excess inventories, allowing brands to pare promotions and boost output.
The tradeoff, of course, is that such a recovery could prevent central banks from the enacting the interest rate cuts that the market seems to expect later this year. After forecasting further hikes for the first half of this year (see the orange columns in the chart below), the futures market has priced in rate cuts beginning in the second half of the year (blue columns) for many of the major central banks.
Market sees hikes in first half of the year, then cuts in second half
Source: Charles Schwab, Bloomberg data as of 2/9/2023.
The chart reflects the futures market implied rate in each country or region. A basis point is one-hundredth of a percentage point, or 0.01%.
It would likely take more global economic and labor weakness, combined with a more rapid decline in price pressures, to prompt such a reversal in policy this year. Rate cuts may not be needed to stimulate economic activity if manufacturing activity is already strengthening.
If economic green shoots do take root, stocks that tend to benefit from rate cuts, such as growth stocks, could suffer, while cyclical value stocks may fare better.
Kevin Gordon, Senior Investment Strategist, contributed to this report.
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