Newsletters — Ferguson Shapiro LLC

2023 Quarterly Market Outlook: Fed on the Brink?

March 30, 2023 Liz Ann Sonders, Kathy Jones, Jeffrey Kleintop

Economic cracks began to appear during the first quarter, capped off by banking system worries. Will it change the direction of Federal Reserve policy?

There's an old saying about Federal Reserve tightening cycles: The Fed "tightens until something breaks." Cracks emerged during the first quarter of this year, as rising rates, tighter lending conditions, and shrinking liquidity weighed on economic growth. The banking system turmoil that emerged near the end of the quarter was an unsettling addition to investor concerns.

On March 22, the Fed raised the federal funds rate by 25 basis points, a move that was widely expected. The question is what the central bank will do next. The Fed is trying to thread a needle in balancing the threats associated with the banking crisis and the need to combat still-high inflation. Fed Chair Jerome Powell made it a point to say there were costs to bringing inflation down to the Fed's 2% target, but the costs associated with allowing inflation to remain high would be more severe.

Either way, there's likely to be more volatility in the coming months, making this a good time to remember the benefits of portfolio diversification, rebalancing, and staying focused on stocks of companies with higher-quality factors—such as stable earnings and reasonable valuations—and higher-credit-quality fixed income investments.

U.S. stocks and economy

The most recent U.S. employment report was mixed, with fairly strong payroll gains (311,000 jobs in February, 504,000 in January) but concurrent increases in the labor force participation rate (to 62.5% from 62.4%) and the unemployment rate (to 3.6% from 3.4%). These last two indicate that more people are coming off the sidelines, looking for work, and not finding it. Slower average hourly earnings growth in February indicated that the labor market is softening, but it should be noted that most of the easing in wage growth has been driven by layoffs in higher-paying industries. Moving down the income spectrum, wage growth remains relatively robust.

The latest consumer price index (CPI) data was mixed, as prices eased somewhat in February from January, but still remain high. "Core" inflation, which excludes volatile food and energy prices, remains above the Fed's comfort zone. We've also seen weaker retail sales and lower-than-expected producer price index data. That could support a pause in the rate-hike cycle that began in 2022.

The reality, however, for those trying to guess what the Fed is likely to do, is that recent issues in the banking system will likely continue to be important factors in the Fed's thinking. It's not a stretch to say these are unlikely to be contained and isolated problems, for the simple reason that we are only starting to wring out the excesses of easy money and ample liquidity.

A little recent background: Beginning in 2020, the COVID-19 pandemic and the commensurate epic monetary and fiscal policy response to it led to a surge in money supply and financial system liquidity. Lending became easier and cheaper, and investors often looked to riskier investments—such as high-yield bonds or "growthier" stocks—in search of higher yields and returns.

However, rising inflation forced a course correction in 2022. During the past year, the Fed has raised the federal funds target rate at the fastest pace in 40 years in an effort to cool the economy and inflation. Not surprisingly, as the tide of liquidity rolled out and economic growth slowed, investors began to reconsider some of these riskier investments.

This has been the fastest pace of rate hikes in decades

Source: Bloomberg, as of 2/28/2023

Federal Funds Target Rate - Upper Bound (FDTR Index), using monthly data. The Federal Open Markets Committee (FOMC) sets the federal funds rate range to guide overnight lending between U.S. banks.

Note: Data is the short-term interest rate targeted by the Federal Reserve's Federal Open Market Committee (FOMC) as part of its monetary policy. Lines represent the cumulative change in the federal funds target rate from the start of each rate-hike cycle shown in the chart (beginning in 1983, 1987, 1994, 1999, 2004, 2015 and the current cycle, which began in 2022).

Fixed income

The banking sector issues shifted the landscape dramatically for fixed income markets at the end of Q1. In early March, Powell suggested the central bank might need to raise short-term interest rates higher than previously expected to fight inflation. But within days, wobbles in the banking sector led to speculation that the Fed might instead pause or slow its rate hikes in an effort to ensure financial stability. As shown in the chart below, markets now expect cuts to the federal funds rate in the second half of the year. However, during the press conference following the March 22nd meeting, Chairman Powell reiterated that cutting rates in 2023 wasn't the Fed's baseline expectation. This difference between what the market expects and what the Fed is saying it expects to do could be a source of volatility going forward.

Expectations for the path of the federal funds rate have shifted lower

Source: Bloomberg, as of 3/17/2023

Market estimate of the federal funds rate using Fed Funds Futures Implied Rate (FFM2 COMB Comdty). For illustrative purposes only.

In addition to its dual mandate to keep inflation in check and to promote full employment, the Fed has a third unwritten mandate: to maintain financial stability. In times of stress, financial stability concerns often trump the other two mandates. The Fed has said it believes the issues in the banking sector are not widespread, but until the outlook is clear, it could cause the Fed to pause its rate hiking cycle until the outlook is clear.

Global stocks and economy

A key issue over the coming months will be the extent to which recent events cause banks to reduce lending. This in turn would weigh on consumer demand and business investment and therefore accelerate the deterioration in the global economy. One of the complex aspects of the current economic slowdown has been the rolling aspect of it. There have been many negative Gross Domestic Product (GDP) quarters lately among the Group of Seven (G7) economies (noted as red on the table below). Yet Canada's oil-driven economy has avoided declines as it benefits from rebounding demand and tight supplies, few of the negative quarters have been back-to-back, and the timing has not been synchronized across all the economies.

Rolling recession

Source: Charles Schwab, Bloomberg, Macrobond, National Sources, data as of 3/12/2023.

*1Q2023 is Bloomberg-tracked economists' consensus forecast.

We could still make the case for declaring a global economic downturn, amplified by the recent banking issues—calling it a recession, a rolling recession, or some sort of "landing." But this unusual rolling characteristic could persist in the months and quarters to come and may mean further market volatility.

Inflation also is not likely to recede in a linear fashion, if history is any guide. Like subsequent waves of COVID, waves of inflation could be milder in their impact on the economy and markets, yet still cause investor nervousness by raising uncertainty about the direction of economic growth, inflation, and central banks' policy responses. It's possible that any upticks in inflation coinciding with the recent wave of growth could delay central banks from declaring an end to rate hikes.

What investors can do now

As we've been saying for a while, it's important during this period of transition to focus on higher-quality factors—such as stable earnings and reasonable valuations—when choosing stocks. This is not a time to take undue risk, in our opinion.

Your portfolio also should contain a mix of investments—including various types of stocks (large-cap, small-cap, domestic, and international), bonds, and cash investments—in appropriate amounts based on your goals, investing time horizon, and risk tolerance.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk including loss of principal.

Diversification, asset allocation, and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Performance may be affected by risks associated with non-diversification, including investments in specific countries or sectors. Additional risks may also include, but are not limited to, investments in foreign securities, especially emerging markets, real estate investment trusts (REITs), fixed income and small capitalization securities. Each individual investor should consider these risks carefully before investing in a particular security or strategy.

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Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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Small-cap stocks are subject to greater volatility than those in other asset categories.

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