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What’s next for stocks as investors realize the Fed’s inflation war won’t end anytime soon?


The stock market will end February with a clear sign of wobble, casting doubt on the durability of a rally in early 2023.

Blame it on stronger-than-expected economic data and hotter-than-expected inflation has forced investors to rethink their expectations of how high the Federal Reserve will push interest rates. any.

“The idea that the stock market is going to be strong while the Fed is still raising rates and the market is undervalued,” said Lauren Goodwin, economist and portfolio strategist at New York Life Investments. what the Fed will do” seems “unacceptable”. in a phone interview.

Market participants have caught up with the Fed’s way of thinking. At the end of January, federal funds futures reflected expectations that the Fed’s benchmark interest rate would peak below 5% despite the central bank’s own forecast for a peak in the 5% to 5.25 range. %. Furthermore, the market was anticipating the Fed to make more than one cut by the end of the year.

That view started to change after the release of the January jobs report on February 3 showed that the US economy had picked up. 517,000 jobs much larger than expected and showed the unemployment rate fell to 3.4% – the lowest level since 1969. January consumer And producer price index and friday bounces in core personal consumption expenditure price indexThe Fed’s preferred inflation measure and the market’s outlook on interest rates look much different.

Participants now see the Fed raising rates above 5% and keeping them there until at least year-end. The question now is whether the Fed will increase its forecast for where interest rates will peak at its next policy meeting in March.

That translates into Treasury reserve yields and a drop in equities, with the S&P 500 down about 5% from the 2023 highs set on Feb. 2, sending it up 3.4% in the year to Friday.

Not only are investors learning to live with Fed rate expectations, but investors are realizing that, said Michael Arone, director of investment strategy for the SPDR business at State Street Global. reducing inflation will be a “bumpy” process. Advisor, in a phone interview. Finally, he noted, former Fed Chairman Paul Volcker had to go through two recessions in the early 1980s to quell the hyperinflation.

The S&P 500 index’s February 2 high was led by what some analysts derisively called a “rush to find trash.” Last year’s biggest losers, including the highly speculative stocks of companies with no earnings, were among those leading the way in the recovery. Those stocks took a particular hit last year when the Fed’s aggressive pace of rate hikes sent Treasury yields surging. Higher bond yields make it harder to justify holding stocks whose valuations are based on expected earnings and cash flows far into the future.

Arone noted that this month’s inflation indicators were all hotter than expected, leading to a “reverse of what was working” before. 10-year Treasury yields have fallen, the dollar is weakening, which means highly speculative, volatile stocks are returning the lead to well-established companies, he said. benefit from rising interest rates and inflation.

The energy sector was the only winner out of the 11 S&P 500 sectors in the past week, while materials and consumer staples outperformed.

Dow Jones Industrial Average
DIA,
-1.02%

fell 3% last week, sending the blue-chip index down 1% so far in 2023, while the S&P 500
SPX,
-1.05%

fell 2.7% and the Nasdaq Composite was heavy on technology
COMPUTER,
-1.69%

down 1.7%. Nasdaq cut its year-to-date gains to 8.9%.

Goodwin sees the possibility of stocks falling another 10% to 15% as the economy slides further into a recession. She said that while earnings results show bottom line continues to be relatively good for the tech and consumer discretionary sectors, top revenue is decelerating – a mismatch. worrying. Outside of the pandemic winners, she noted, companies are struggling to maintain profit margins.

Indeed, margin trouble could be the next big worry, Arone said.

Net profit margin is lower than the 5-year average as businesses have reached their limit when turning to high-priced customers.

“My view is that this will remain a headwind for the outlook for equities and something that is a bit on the horizon,” he said. That could explain why sectors that still have high margins or are likely to increase margins – such as the aforementioned energy and industrials – outperformed the market last weekend. .

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