Batten Down the Hatches

HIGHLIGHTS:

• January's CPI print showed that inflation slowed only marginally to a 6.4 percent annualized rate, higher than predictions.
• While more volatile food and energy prices contributed, shelter remained a key driver of inflation.
• Financial markets reacted with higher bond yields and choppier trading in stocks as companies continued to report their results.
• A majority of S&P 500 companies have reported their Q4 results and earnings have declined by 2.4 percent so far.

Shares climbed markedly higher in the first few weeks of the year, but have faltered in recent days as the Federal Reserve's outlook became hazy. On cue last week, the Fed raised its key overnight rate—the federal funds rate—by 25 basis points to a range of 4.50 percent to 4.75 percent. The move came like clockwork and was widely expected by the market over a larger hike after data showed inflation slowed to a rate of 6.5 percent in December. Officials seem confident that their actions to combat rising consumer prices are working, with Fed Chair Jerome Powell proclaiming, "the disinflationary process has begun."

However, while the Fed was raising rates and claiming victory, the real story was unfolding. On Friday, the US Bureau of Labor Statistics released its all-important jobs report, and the results surprised many. The US economy in January added a whopping 517,000 jobs, reflecting accelerating labor market growth and bringing the US unemployment figure down to 3.4 percent—a 50-year low. The release was almost three times higher than estimates—a more "normal" figure for monthly job gains is around the 200,000 mark.

While this represents a strong positive for workers, it is the opposite of what the Fed is looking for. Monetary policy and the labor market have a strong relationship. Typically, restrictive policy eventually leads to higher unemployment with slower wage growth and—the main goal—lower inflation. It's important to note that this is a single data point, and there have been more than a handful of stellar jobs numbers in the post-pandemic era. Going forward, Fed officials will be watching labor market data closely, particularly if the trend continues and enough momentum builds up to push wages—and inflation—higher.

Investors are scrutinizing the so-called "Fedspeak" to see if officials pivot yet again to a more hawkish stance. For now, it seems that central bankers are holding steady with their guidance for two more hikes before pausing. The markets agree. Futures data reflect investors betting on one 25 basis point hike at the Fed's meeting in March and another in May—reaching its target rate of about 5.0 percent. It's unlikely that things will end up so cut and dry. There are still opportunities for the labor market and inflation to surprise to the upside. If that happens amid a tangible slowdown in other parts of the economy, the Fed could have a real problem on its hands.

Market mariners scanning the horizon for signs of calm seas and smooth sailing on Tuesday morning found more storm clouds in their spyglass. The US Department of Labor said the annual inflation rate came in at 6.4 percent in January and 0.5 percent for the month versus December. While continuing marginally lower from December, the annualized number was higher than the 6.2 percent forecasted by economists. Stripping out the ever-volatile food and energy components, the annualized core inflation reading was 5.6 percent—also higher than forecasted. Despite seas having calmed from last year's tempest of inflation reports, the monthly rise from December shows storm clouds persist.

The biggest contributor to the stubbornly high CPI reading continues to be shelter costs, which rose 7.9 percent for the year and accounted for nearly half the monthly increase. Energy costs are up 8.7 percent year-over-year, while food was up about 10 percent. These data points are sending the same message to markets: Inflation is not running as hot as it was several months ago, but it has not yet been fully tamed.

While equity markets swung between gains and losses after the release, bond prices took on water as the Fed now has more impetus to continue its rate hike regimen. The yield of the six-month T-bill, considered a barometer of fed funds moves to come, rose 8 basis points—cresting over the 5 percent level. Further out on the yield curve, the 10-year Treasury saw rates rise 4 basis points, climbing back to 3.75 percent.

Meanwhile, fourth-quarter earnings season is beginning to wind down with 370 companies of the S&P 500 having reported their results. Thus far, corporate results do not appear to offer safe harbor from the economic waves. While earnings are beating estimates, year-over-year earnings growth is currently down 2.4 percent. That would represent the first annual decline in earnings since the third quarter of 2020, in the midst of the pandemic shutdown. An additional concern is the divergence of earnings results from stock prices as evidenced in the recent jump in price-earnings ratios.

Mariners will often push through stormy seas if they see safer waters ahead. But proper ballast and the willingness to ride the waves are required. Markets are hoping that the second half of 2023 provides those calmer seas, if they can only get there safely.

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