2023 Quarterly Market Outlook: Fed on the Brink?
There's an old saying about Federal Reserve tightening cycles: The Fed "tightens until something breaks." Cracks emerged during the first quarter of this year, as rising rates, tighter lending conditions, and shrinking liquidity weighed on economic growth. The banking system turmoil that emerged near the end of the quarter was an unsettling addition to investor concerns.
On March 22, the Fed raised the federal funds rate by 25 basis points, a move that was widely expected. The question is what the central bank will do next. The Fed is trying to thread a needle in balancing the threats associated with the banking crisis and the need to combat still-high inflation. Fed Chair Jerome Powell made it a point to say there were costs to bringing inflation down to the Fed's 2% target, but the costs associated with allowing inflation to remain high would be more severe.
Either way, there's likely to be more volatility in the coming months, making this a good time to remember the benefits of portfolio diversification, rebalancing, and staying focused on stocks of companies with higher-quality factors—such as stable earnings and reasonable valuations—and higher-credit-quality fixed income investments.
U.S. stocks and economy
The most recent U.S. employment report was mixed, with fairly strong payroll gains (311,000 jobs in February, 504,000 in January) but concurrent increases in the labor force participation rate (to 62.5% from 62.4%) and the unemployment rate (to 3.6% from 3.4%). These last two indicate that more people are coming off the sidelines, looking for work, and not finding it. Slower average hourly earnings growth in February indicated that the labor market is softening, but it should be noted that most of the easing in wage growth has been driven by layoffs in higher-paying industries. Moving down the income spectrum, wage growth remains relatively robust.
The latest consumer price index (CPI) data was mixed, as prices eased somewhat in February from January, but still remain high. "Core" inflation, which excludes volatile food and energy prices, remains above the Fed's comfort zone. We've also seen weaker retail sales and lower-than-expected producer price index data. That could support a pause in the rate-hike cycle that began in 2022.
The reality, however, for those trying to guess what the Fed is likely to do, is that recent issues in the banking system will likely continue to be important factors in the Fed's thinking. It's not a stretch to say these are unlikely to be contained and isolated problems, for the simple reason that we are only starting to wring out the excesses of easy money and ample liquidity.
A little recent background: Beginning in 2020, the COVID-19 pandemic and the commensurate epic monetary and fiscal policy response to it led to a surge in money supply and financial system liquidity. Lending became easier and cheaper, and investors often looked to riskier investments—such as high-yield bonds or "growthier" stocks—in search of higher yields and returns.
However, rising inflation forced a course correction in 2022. During the past year, the Fed has raised the federal funds target rate at the fastest pace in 40 years in an effort to cool the economy and inflation. Not surprisingly, as the tide of liquidity rolled out and economic growth slowed, investors began to reconsider some of these riskier investments.
This has been the fastest pace of rate hikes in decades
Source: Bloomberg, as of 2/28/2023
Federal Funds Target Rate - Upper Bound (FDTR Index), using monthly data. The Federal Open Markets Committee (FOMC) sets the federal funds rate range to guide overnight lending between U.S. banks.
Note: Data is the short-term interest rate targeted by the Federal Reserve's Federal Open Market Committee (FOMC) as part of its monetary policy. Lines represent the cumulative change in the federal funds target rate from the start of each rate-hike cycle shown in the chart (beginning in 1983, 1987, 1994, 1999, 2004, 2015 and the current cycle, which began in 2022).
The banking sector issues shifted the landscape dramatically for fixed income markets at the end of Q1. In early March, Powell suggested the central bank might need to raise short-term interest rates higher than previously expected to fight inflation. But within days, wobbles in the banking sector led to speculation that the Fed might instead pause or slow its rate hikes in an effort to ensure financial stability. As shown in the chart below, markets now expect cuts to the federal funds rate in the second half of the year. However, during the press conference following the March 22nd meeting, Chairman Powell reiterated that cutting rates in 2023 wasn't the Fed's baseline expectation. This difference between what the market expects and what the Fed is saying it expects to do could be a source of volatility going forward.
Expectations for the path of the federal funds rate have shifted lower
Source: Bloomberg, as of 3/17/2023
Market estimate of the federal funds rate using Fed Funds Futures Implied Rate (FFM2 COMB Comdty). For illustrative purposes only.
In addition to its dual mandate to keep inflation in check and to promote full employment, the Fed has a third unwritten mandate: to maintain financial stability. In times of stress, financial stability concerns often trump the other two mandates. The Fed has said it believes the issues in the banking sector are not widespread, but until the outlook is clear, it could cause the Fed to pause its rate hiking cycle until the outlook is clear.
Global stocks and economy
A key issue over the coming months will be the extent to which recent events cause banks to reduce lending. This in turn would weigh on consumer demand and business investment and therefore accelerate the deterioration in the global economy. One of the complex aspects of the current economic slowdown has been the rolling aspect of it. There have been many negative Gross Domestic Product (GDP) quarters lately among the Group of Seven (G7) economies (noted as red on the table below). Yet Canada's oil-driven economy has avoided declines as it benefits from rebounding demand and tight supplies, few of the negative quarters have been back-to-back, and the timing has not been synchronized across all the economies.
Source: Charles Schwab, Bloomberg, Macrobond, National Sources, data as of 3/12/2023.
*1Q2023 is Bloomberg-tracked economists' consensus forecast.
We could still make the case for declaring a global economic downturn, amplified by the recent banking issues—calling it a recession, a rolling recession, or some sort of "landing." But this unusual rolling characteristic could persist in the months and quarters to come and may mean further market volatility.
Inflation also is not likely to recede in a linear fashion, if history is any guide. Like subsequent waves of COVID, waves of inflation could be milder in their impact on the economy and markets, yet still cause investor nervousness by raising uncertainty about the direction of economic growth, inflation, and central banks' policy responses. It's possible that any upticks in inflation coinciding with the recent wave of growth could delay central banks from declaring an end to rate hikes.
What investors can do now
As we've been saying for a while, it's important during this period of transition to focus on higher-quality factors—such as stable earnings and reasonable valuations—when choosing stocks. This is not a time to take undue risk, in our opinion.
Your portfolio also should contain a mix of investments—including various types of stocks (large-cap, small-cap, domestic, and international), bonds, and cash investments—in appropriate amounts based on your goals, investing time horizon, and risk tolerance.
It's also important to rebalance your portfolio regularly (for instance, once a year). Over time, market changes can skew your allocation from its original target: Assets that have gained in value will account for more of your portfolio, while those that have declined will account for less. Rebalancing means selling positions that have become overweight in relation to the rest of your portfolio, and moving the proceeds to positions that have become underweight. It's a good idea to do this at regular intervals. Schwab clients can log in and use the Schwab Portfolio Checkup tool to identify areas of their portfolio that may have drifted away from their target asset allocation.