A Welcome Sight

Friday Reflection

Following its worst yearly performance in over a decade, the S&P 500 started off 2023 with an impressive January. The benchmark index gained more than 6% for the month as investors bid up prices, and the first wave of Q4 earnings reports came in better than many had feared.  

The economic and market landscape still includes plenty of uncertainty, but it is a welcome sight to see portfolios rebuild some value early in the year. Inflation data suggests that the dramatic interest rate hikes implemented by the Federal Reserve have started to cool off red-hot wage and consumer price increases, while recent labor market reports show that the US economy has remained resilient. With growing confidence that the Fed won’t have to repeat last year’s pace of rate hikes, the US bond market grew by 3.3% in January alongside the rally in stock prices. 

While we cannot predict where prices will end up, diversified portfolios are positioned to provide an improved return profile for investors in the year ahead. 

The reality is that for long-term investors, a lower purchase price means less risk. While the recent adjustment period was painful, we currently see a stock market with less forward-looking risk than one year ago. The same is true, perhaps even more so, in the bond market. 2022 began with interest rates barely above zero and with only one direction to go – higher. Today, bonds are paying improved yields to investors, and the current Fed Funds rate is 4.50-4.75%, with expectations for limited rate hikes over the remainder of the year. This presents a far more favorable landscape for fixed income investors and a likely return to more normal patterns of income and ballast within diversified portfolios.  

There is also the fact that segments of the economy have started the year better than expected. The most recent jobs report showed that the US economy added a whopping 517,000 jobs in January, according to the Bureau of Labor Statistics.[1] The unemployment rate ticked down slightly to 3.4% – the lowest jobless rate since May 1969. Earlier this week, Treasury Secretary Janet Yellen touted these gains by declaring that “you don’t have a recession when you have 500,000 jobs and the lowest unemployment rate in 50 years.”

While we aren’t as convinced that the US will avoid a recession entirely, we do agree that the resilience of the US labor market may be the most convincing indicator that a soft landing is still possible. 

Ironically, the strong US labor market is simultaneously a risk factor for market prices. If the tight labor market leads to a re-emergence of wage inflation, the Fed will have a harder time getting back to its long-term inflation target. There are concerns that the downward path of inflation will hit a sticky patch at around 4% later this year, and the Fed will need to keep interest rates higher for longer.  

Fed Chair Jerome Powell acknowledged earlier this week that the process of disinflation is underway, but he also emphasized that “we have a significant road ahead to get inflation down to 2%. There has been an expectation that it’ll go away quickly and painlessly. I don’t think that’s at all guaranteed.” The consensus is that the Fed will increase by another 25 bps at their March and May meetings and then will pause to assess whether further action is needed. If rates need to be pushed even higher, equity markets will likely experience short-term turbulence while expectations are recalibrated. 

While the overall labor market appears strong, some investors are concerned about the growing number of big tech companies issuing layoffs. Zoom and eBay announced layoffs this week, joining the ranks of Dell, Okta, Spotify, Google, Intel, Microsoft, and Amazon in reducing the size of their workforces. Even though most large tech companies still maintain workforces that are much larger than they were just a couple of years ago, it is noteworthy that more than 100,000 global technology-sector employees have been laid off since the start of 2023.[2] Long-term, this is a natural ebb and flow in tech hiring cycles, but in the short-term, it means a lot of highly paid workers who won’t be contributing to the economy in the same ways. 

Financial markets have already priced in some of these potential risks as part of last year’s dramatic declines, and the next chapter in investment markets is starting from a more appealing valuation level. Even with opportunity starting to blossom, the Fed recently cautioned investors that “this process is likely to take quite a bit of time, it’s not going to be smooth, it’s probably going to be bumpy.”  

The bottom line is that inflation isn’t vanquished yet, and the Fed isn’t done tightening yet. Current interest rate and valuation levels provide reasons to be hopeful, with diversified portfolios poised for better relative performance in the year ahead.

Resources
1 The Employment Situation – January 2023 U.S. Bureau of Labor Statistics  
2 Data aggregated by Layoffs Tracker Layoffs.fyi