Three Conditions for a Sustainable Recovery

DEWITT, Mich. - March 8, 2023 - PRLog -- After a strong start to the year, market volatility in both stocks and bonds seems to have returned. Despite markets moving higher last week, the S&P 500 year-to-date returns have gone from 9.0% earlier in the year, to around 4.5% now, about a 5% correction from recent highs. Meanwhile, in the bond space, short term and long-term government bond yields have moved notably higher in recent weeks, with the 2-year Treasury yield approaching decade highs¹. This latest bout of volatility in markets has been driven by a few factors, including stronger than expected labor and inflation data.

While we would expect market volatility to continue near-term, we are also watching for key inflection points this year that may indicate the early innings of a more sustainable rally ahead.

Three conditions for a sustainable recovery:

1. Inflation moving lower, preferably by a cooling in services inflation: While headline inflation has been moving lower since its peak in June 2022, we have seen data more recently point to mixed outcomes, with better labor market and consumer data offset by softer manufacturing trends. In particular, services inflation – driven by a strong labor market and higher wage gains – continues to exceed expectations and keep inflation elevated. In fact, we saw just this past week that unit labor cost data for the fourth quarter came in at 3.2% annualized, well above expectations for a 1.6% growth rate, further evidence that wage gains have yet to meaningfully ease.

2. The Fed moving to the sidelines: Given ongoing inflationary pressures, market expectations for Fed rate hikes have notably increased since the start of the year. Market forecasts now call for three additional rate hikes in 2023 (in the March, May and June FOMC meetings), which would bring the fed funds rate to around 5.5%. Given the recent strength in the labor market, we would expect the Fed to raise rates at least twice more, in 0.25% increments.

3. Earnings revisions bottoming: We are now over 95% through fourth quarter S&P 500 earnings, which have been mixed at best, with earnings growth for the quarter tracking to about -4.6% year-over-year. Overall, earnings estimates have also come down substantially for the full year 2023, from about 10% last June, to under 2.0% today¹. While this has been a meaningful downward revision, we believe earning forecasts for this year may continue to fall, perhaps slightly into negative territory, especially if an economic slowdown materializes in the back half of this year. Nonetheless, markets tend to be forward looking and will likely start to look through this trough period and toward a recovery ahead.

Source: 1. Bloomberg