I’m Only the Piano Player

Mar 7, 2023

By Ben Norris, CFA, Securities Research Analyst, Associate Vice President
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Treasury yields continued their climb last week as the market increasingly expects the Fed Funds terminal rate to reach the mid-5% range this year. The 10-year Treasury yield briefly topped 4% last week while the 2-year yield neared 5%. The yield on the 10-year hasn’t been this high since 2010 when effects from the Great Recession were still lingering in global financial markets. Similarly, the 2-year hasn’t seen a yield this high since 2007. Expectations for higher terminal rates have taken hold recently as it becomes clear that the Fed hasn’t made as much progress in bringing down inflation as they had hoped after hiking rates by nearly 5%. Unexpectedly strong economic data has been a thorn in the Fed’s side and has caused investors to rethink their views on future U.S. monetary policy. After February’s Federal Open Market Committee (FOMC) meeting, markets were pricing in a terminal rate of 4.9% and a year-end rate of 4.4%, implying that the Fed would begin to ease before the end of 2023. Resilient employment, strong consumer activity (most recently retail sales), and inflation data have led to a more hawkish view from markets. The expected terminal rate is now 5.4% and no rate cuts are anticipated until 2024.

Markets were pressured in February precisely because investors began to worry that rates would remain higher than expected for longer than expected. I’m skeptical of the current market rally because, if anything, we’re in a less promising position from both an interest rate and economic indicator perspective than we were a few weeks ago. Rates are almost certainly going to continue their move higher, and based on historical trends, this is not positive for equity market valuations. In fact, just as the 2-year Treasury yield climbed to a cycle high last month, stocks fell across the board. Why now, should investors feel differently? The simple answer is, they shouldn’t. It looks likely that rates are going to continue to march higher in 2023 and corporate earnings are going to enter a recession. The fourth-quarter 2022 earnings season is nearly over and the rate at which companies beat expectations fell to its lowest level in 12 years. At the same time, the S&P 500 (SPX) is projected to see a 4% year-over-year decline in earnings this quarter followed by two more quarters of negative earnings growth. The expected earnings growth rate in 2023 is now slightly negative according to S&P Capital IQ estimates, down significantly from initial estimates for mid-single-digit growth.

As we wrote last week, the odds of a recession in 2023 or 2024 remain elevated despite mixed economic data. While the U.S. labor market and consumer activity have both remained surprisingly resilient, other areas of the economy have begun to show cracks. We’ve taken to calling the current economic situation a “rolling recession,” in which certain components of the economy are flashing recession-like warning signs and risk increases as the contagion expands to other areas. Three areas we believe are already in a recession are technology, housing, and manufacturing.

Major technology companies have announced a slew of layoffs over the last several months and recent management commentary has indicated that they are prepared for slowing demand. Housing has been affected by both higher interest rates and elevated prices versus pre-pandemic levels. So, while prices have come down (especially in major cities) recently, they are still up more than 30% since February 2020 according to the Case-Shiller Home Price index. We feel that the lack of affordability, in large part due to a doubling in average mortgage rates, will weigh on consumers and could mean prices have more room to fall. Manufacturing activity has also seen a deterioration in recent readings according to the Institute for Supply Management’s Manufacturing Index, which has been in contraction territory for four consecutive months. Finally, the Conference Board’s Leading Economic Indicators (LEIs) has been in negative territory for 10 straight months. Every prior stretch of 10 consecutive negative readings for LEIs has preceded a recession.

Last week began on a positive note as stocks were led to a slight gain by the Technology and Consumer Discretionary sectors, a welcome turnaround from the prior week that marked the worst weekly performance in months. Durable goods orders came in weaker than expected for the January period, further supporting the slowing economy narrative. Tuesday, the final day of February, saw stocks close slightly lower with the Dow Jones Industrial Average (DJIA) underperforming relative to SPX and the NASDAQ Composite (COMP). The 10-year Treasury yield reached its highest level since November on Tuesday while the Conference Board reported that the Consumer Confidence Index decreased in February for the second straight month. February saw SPX, DJIA, and COMP fall 2.6%, 4.2%, and 1.1%, respectively. Higher interest rates tend to weigh on growth stocks, so it was surprising to see growth heavy COMP outperform in a month in which interest rates retested recent highs.

Wednesday’s ISM Manufacturing index saw a slight improvement from the prior month but remained in contraction territory. The prices paid component of the index, which came in at 51.3 versus 44.5 in January, reiterated the notion that the Fed has work to do in its fight against inflation. Stocks closed lower as bond yields continued to climb and investors weighed the ISM report. Thursday saw a relief rally for stocks as Atlanta Fed President Raphael Bostic made comments that were perceived as dovish. Bostic indicated that the Fed may be in a position to pause their current tightening cycle by third quarter of this year. The DJIA gained 1.1% while COMP and SPX saw a gains of 0.8% and 0.7%. Initial and continuing jobless claims remained near historic lows in Thursday’s reading and the U.S. Bureau of Labor Statistics reported that unit labor costs increased 3.2% in fourth quarter 2022. The increase in labor costs is another reading that points to sticky inflation. In contrast to Wednesday’s ISM Manufacturing reading, the ISM Services index remaining firmly in expansion territory, highlighting the contrast between the outlook for goods and services economies in the U.S. Friday saw stocks close sharply higher, once again led by the Technology and Consumer Discretionary sectors. Each of the 11 equity sectors closed in positive territory. The strong finish to the week helped stocks snap a multi-week losing streak.

When I put together my thoughts for these comments each week, I try my best to present both the positive and negative developments for the markets and the economy. I’m sensitive to the fact that our comments have tilted more negative lately, which has me feeling a bit like the title of Elton John’s sixth album Don’t Shoot Me I’m Only the Piano Player. While we’re not currently bullish on equity markets, I do want to highlight the fact that on a relative basis it is an attractive time to be a bond investor. Yields haven’t been this high in more than a decade and credit quality has remained solid so far. Receiving a 4% yield on Treasuries and potentially 5%-6% for taking a little credit risk is an attractive proposition, especially as inflation continues to work its way lower over the next several quarters.

The highlight of the coming week will be Wednesday with both the ADP Employment Report and the Fed’s Beige Book. Rounding out the week we’ll get an update on the U.S. Budget as well as more employment data.

Date Report Previous Consensus
Monday 3/6/2023 Factory Orders (January) +1.8% -1.8%
Tuesday 3/7/2023 Wholesale Inventories (January) 0.1% -0.4%
Consumer Credit (January) $11.6B $25.0B
Wednesday 3/8/2023 ADP Employment Report (February) 106,000 210,000
U.S. Trade Balance (January) -$67.4B -$68.7B
Job Openings (JOLTS, January) 11.0M
Federal Reserve Beige Book
Thursday 3/9/2023 Initial Jobless Claims (March 3) 190,000 193,000
Friday 3/10/2023 Employment Report (February) 517,000
U.S. Unemployment Rate (February) 3.4% 3.4%
Federal Budget Balance -$217B


Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Weekly Market Commentary/Market