Investor fear shifts to confusion as the Fed hints at rate hikes

Thoughts

• Markets escaped a four-week losing streak last week with the help of a Friday rally, though investors continue to express concern. Equity markets are set to close January with a loss of roughly 7%, the worst month since the pandemic-related bear market. While investors reacted to fear two weeks ago, with a weekly loss for the S&P 500® Index of nearly 6%, last week was characterized by confusion, with daily trading ranges averaging 3.4%, but the week closing with a near 1% gain after briefly entering correction territory. Bond investors fear a Fed misstep, with the yield curve at the flattest level since October 2020.
• The past month has seen a sharp deterioration in investor confidence. Wall Street strategists have shifted to a more bearish tone, with Morgan Stanley and Goldman Sachs seeing 10% of additional downside. Sentiment indicators reflect substantial stress, with the AAII Sentiment Survey showing the bull-to-bear ratio at the weakest level since 2013. The CNN Fear & Greed Index fell to 38 on a scale from 0-100, down from 60 a month ago. Concern over the Fed is a primary reason for bearishness, though the S&P 500 has been higher in the 12 months following the initial hike in each of the last seven rate cycles.
• Some Wall Street analysts expect markets to slide even further from here, however, there are signs that we’ve already begun the bottoming process. Investor behavior began a shift last week away from fear of intangible factors, like COVID and Congress, towards more tangible signals like earnings. Expect this to result in a sideways movement with some volatility in the lead-up to March’s potential rate hike, after which equity markets should regain an upward trajectory.

News

• Earnings season is tracking modestly better than expected with one-third of the S&P 500 companies having reported, with a blended growth rate of 24% compared to an expected 22% at the beginning of the quarter. Of those reporting, the beat rate (77%) is modestly above the 5-year average, but the percentage beat (4%) is below average. Margins have been notably resilient given the supply chain and labor issues, with operating margins expected at record levels this year. The market reaction to earnings has been subdued, with less than one-third of companies moving higher following the release. Management commentaries have been cautious given the uncertainties, resulting in modestly negative revisions to first-quarter results.
• Inflation remains a significant worry of investors and an increasing concern of the Federal Reserve, as indicated in Chair Powell’s comments following the FOMC meeting. The core PCE deflator (inflation metric favored by the Fed) jumped by a faster-than-expected 4.9% from a year ago, the highest pace since 1983. The headline number (including food and energy) rose 5.8%. Wage growth per the Employment Cost Index rose 4% from a year ago, the fastest pace in history dating back to 2002, but below the level of core inflation, suggesting deteriorating purchasing power. Despite the wage growth, personal spending fell 0.6% in December (worse if inflation is factored in), a reversal of the 0.4% growth in November, suggesting consumers bought ahead for Christmas on worries around supply chain issues. Fourth-quarter GDP grew at a better-than-expected 6.9%, registering the best full year of growth since 1984, driven by inventories, consumer spending, and business investment. The pace of growth is forecast to slow to less than 0.1% in the first quarter per the Atlanta Fed’s GDPNow model.
• Investors continue to fixate on the FOMC, following a two-day meeting that provided a clearer path forward for policy. Chair Powell suggested “lift off” in the Federal Funds rate could come in March, noting that “There’s quite a bit of room to raise interest rates without threatening the labor market.” Additionally, the tapering of bond purchases will conclude in March, though there were no specific details on when they would begin to shrink the balance sheet. The Fed Futures curve embeds a 71% chance of five-or-more hikes this year, up from 12% a month ago. Equity markets turned notably negative during his press conference, as his tone was more hawkish than expected, particularly given the recent deterioration in economic data.

What to Watch

• Earnings data will be the primary area of focus this week, with several high-profile releases. The economic calendar includes PMI data and JOLTS Job Openings on Tuesday, productivity, durable goods, and ISM data on Thursday, and the monthly payroll report on Friday.