By Ben Norris, CFA, Securities Research Analyst, Associate Vice President
Print This Post
Stocks saw their worst performance since mid-December last week amidst relative weakness in growth and small-cap stocks. Treasury yields rose throughout the week as investors expect higher interest rates through 2023 as the Federal Reserve (Fed) maintains its hawkish tilt. Up until recently, the consensus expectation was that the Fed would go ahead with two 0.25% rate hikes in 2023 before pausing to assess the inflation and economic growth pictures. U.S. economic indicators, particularly employment figures, have been surprisingly resilient despite the Fed’s best efforts to cool the labor market and suppress wage growth. We’re just two weeks removed from a Nonfarm Payrolls report that nearly tripled expectations, while initial and continuing jobless claims remain near historic lows. Because of the ongoing strength in certain areas of the economy, the market is now predicting that the Fed will go ahead with an additional 0.25% rate hike, taking the total increase in the target rates to 0.75% (three 0.25% moves) in 2023. If that is in fact the case, the Fed’s target rate will reach 5%-5.25%, a level unthinkable a year ago when the target was just 0.25%.
The move higher in rates was the primary catalyst for the weakness seen in growth and small-cap stocks last week – lower rates tend to benefit these companies. Several Fed officials indicated last week that the eventual level of rates might be higher than expected or the length of time rates remain elevated could be longer than expected. In fact, the 10-year Treasury yield rose 0.21% last week and the 2-year/10-year Treasury yield spread further inverted. An inverted Treasury yield curve has preceded each of the last several recessions. Despite higher rates and an inverted yield curve, growth has been on a heater so far in 2023 with the Russell 1000 Growth up 9.6% year-to-date, outpacing the Russell 1000 Value’s 4.6% gain. Similarly, the Russell 2000 (a small-cap stock index) has gained 9.1% in 2023 while the Dow Jones Industrial Average (DJIA) has gained just 2.3%.
As we’ve written a few times already this year, it felt like the move in growth stocks was too far too fast in some cases as earnings haven’t kept up with expanding valuations. The fourth-quarter 2022 earnings season is winding down and it has been disappointing at best. The S&P 500 (SPX) is on track to report its first quarterly earnings decline since the pandemic-affected third quarter of 2020. Current expectations are for a 4.9% decline by the time this season concludes. Ironically, the two best performing S&P 500 sectors so far in 2023 – Consumer Discretionary and Communication Services – are set to see the worst earnings declines this quarter.
Unfortunately, consensus estimates see SPX earnings declining in the next two quarters as well with -5.1% and -3.3% growth rates, respectively. So, while SPX has gained 6.7% this year, its rise hasn’t been supported by a corresponding increase in earnings. A gain in prices on lower earnings means that valuations have gone up – a surprising development in a rising rate environment. The forward 12-month price-to-earnings ratio for SPX is now up to 18.0x, vs. 16.7x at the end of 2022. The math here doesn’t add up. While short-term dislocations between earnings and prices are not uncommon, fundamentals rule over the long term. Unless we get a surprise bump in earnings growth or rates stop going up, I don’t see stocks moving much higher from here.
Last week began on a sour note as mega-cap growth stocks pulled the market lower while yields rose significantly. Technology and Communications Services stocks fell more than 1% while Utilities stocks gained 0.9%. The apprehension from traders on Monday was linked to the prior week’s strong employment numbers and the possibility that the Fed would keep restrictive policy in place well into the future. Former Chair of the Fed and current U.S. Treasury Secretary Janet Yellen said on Monday that she didn’t foresee a recession, noting that unemployment is the lowest it’s been in more than 50 years. She essentially made a case for the Fed achieving a “soft landing” with inflation coming back to its long-term target range without the economy entering a recession.
Trading on Tuesday was nearly the exact opposite as stocks closed significantly higher led by the Technology and Energy sectors. Fed Chair Jerome Powell made comments that indicated he saw inflation coming down significantly over the next two years as long as the Fed stayed on its current course. In a repeat of Monday’s trading, large-cap Technology stocks led the market lower on Wednesday. Once again, comments from Fed officials were front and center in traders’ minds and worries about overly hawkish monetary policy bubbled to the surface. Markets flip-flopped once again on the final two days of the week. Stocks fell Thursday before gaining back some ground on Friday. Yields continued to rise through the end of the week, further underlining the discrepancy between the recent surge in growth stocks and their weak financial results. A Friday report showing that consumer sentiment hit a 13-month high helped ease some investor concern to round out the week. While Friday saw a higher close, enough damage had been done earlier in the week to see each of the major indices close lower. DJIA, SPX, and the Nasdaq Composite (COMP) lost 0.2%, 1.1%, and 2.4%, respectively.
The highlight of the coming week will be Tuesday’s Consumer Price Index (CPI) report. The last report saw a noticeable slowdown in price increases but expectations for this report aren’t quite as rosy. Later in the week we’ll get updates on retail sales, industrial production, capacity utilization, and the typical initial and continuing jobless claims. Expect volatility around the CPI report if it comes in much higher or lower than consensus expectations.
|Monday 2/13/2023||NY Fed 1-year Inflation Expectations||5.0%||—|
|Tuesday 2/14/2023||NFIB Small Business Index (January)||89.8||90.0|
|Consumer Price Index (January, y/y)||6.5%||6.2%|
|Core CPI (January, y/y)||5.7%||5.4%|
|Wednesday 2/15/2023||Retail Sales (January)||-1.1%||1.7%|
|Industrial Production (January)||-0.7%||0.4%|
|Capacity Utilization Rate||78.8%||79.0%|
|NAHB Home Builders’ Index||35||36|
|Thursday 2/16/2023||Initial Jobless Claims (Feb. 11)||196,000||200,000|
|Continuing Jobless Claims (Feb. 4)||1.69M||—|
|Producer Price Index (January)||-0.5%||0.4%|
|Philadelphia Fed Manufacturing Survey||-8.9||-7.4|
|Friday 2/17/2023||Import Price Index (January)||0.4%||-0.1%|
|Index of Leading Economic Indicators||-1.0%||-0.4%|
Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Weekly Market Commentary/Market