Fed concerns causing a cautious shift among investors

Thoughts

• Equity markets continued their sluggish start to the year, though the S&P 500^® Index begins the week just 2% below the record high. Below the surface, volatility is intense, with 220 companies with market caps above $10 billion in bear market territory, per the WSJ, and nearly half of the NASDAQ has already seen a 10% correction this year. Surging bond yields continue to be the story early in 2022, with the 2-year Treasury yield above 1.00% for the first time since before the pandemic. The 10-year yield has added 0.30% this year to 1.81%.
• The move in interest rates has disproportionately impacted expensive technology companies, with the Russell 1000^® Growth Index underperforming the Russell 1000^® Value Index by more than 6% in two weeks. Investment managers remain bullish per a Bank of America survey, holding the largest overweight of equities versus bonds in over a decade. The survey showed a substantial shift from growth to value, while the Fed was overwhelmingly identified as the largest risk.
• Modest index declines mask the declines experienced for the average company and the “risk-off” environment.

News

• Commentary from Federal Reserve officials was plentiful last week, highlighted by confirmation hearings for Chair Powell and Vice Chair Brainard. Powell told Congress that he expects the Fed to begin shrinking the $8.8 trillion balance sheet later this year. Brainard signaled openness to a rate hike in March, which was echoed by San Francisco’s President Daly. Board member Waller said that high inflation caught the central bank off guard, and while three hikes this year is a “good baseline,” persistently high inflation could result in four or five. Fed officials now enter a “blackout period” that will keep them from speaking publicly until after next week’s FOMC meeting. The Fed Funds futures curve embeds a 90% chance of a hike in March, up from 49% a month ago, and a 68% chance of four-or-more hikes this year, up from 40% a month ago.
• Economic data continue to soften, providing an additional challenge to the Fed’s decision-making. Retail sales fell more than expected, as high prices and lack of availability of products discouraged purchases. Sales fell 1.9% from November, led by restaurants, furniture and home furnishing, sporting goods, music, and books. Online spending fell a remarkable 8.7% for the month. Consumer price inflation rose 7.1%, the highest since 1982, while producer prices jumped 9.8%, the second-fastest on record (slightly below November) dating back to 2010. Consumer sentiment and industrial production also disappointed to the downside. The NY Fed’s Weekly Economic Index measures high-frequency data and has fallen below a 7% pace for the first time since last March due to decreases in rail traffic and fuel purchases, along with a bounce in initial unemployment claims.
• Earnings season unofficially began this week, though the bulk of releases is set for the next three weeks. The current consensus estimate is for growth of 22%, which would mark the fourth straight quarter above 20% growth. Revenue growth of 13% would mark the third-fastest growth rate since Factset began tracking the metric in 2009. Coming into earnings season, 56 companies in the S&P 500 have issued negative, compared with 37 with positive guidance, marking the first time since the second quarter of 2020 that negative preannouncements were higher than positive, led by technology and industrials. Management commentary around demand patterns, supply chain challenges, and labor shortages will be critical in forecasting margins for the year. Beyond the fourth quarter, growth is expected to slow to 6% in the first quarter and 4% in the second quarter as comparisons become more difficult.

What to Watch

• Earnings season accelerates this week, likely setting the tone for trading. A relatively light week of economic data includes housing starts on Wednesday, existing home sales on Thursday, and the index of leading indicators on Friday.