Celebrating 17 Years of Service

February Newsletter

Feb 13, 2023

MARKETS RALLY TO START THE YEAR

Markets have rallied to start the year against a backdrop of resilient (albeit slowing) global economic growth, declining inflation concerns, and the potential that the Federal Reserve will end its current monetary tightening cycle.

In January, the Dow Jones Industrial Average rose by 2.83%, and the Standard & Poor’s 500 Index increased by 6.18%, with growth stocks outpacing value stocks. European and Chinese equities have also rallied as fears of a “cold winter” in Europe have dissipated, and China has shifted away from zero-COVID policies, which support the continued reopening of their economy.

While the recent market rally is a welcomed sight after a challenging year in 2022, we expect continued periods of volatility as investors navigate mixed economic data. In addition, uncertainty remains as S&P 500 earnings are expected to decline, and profit margins will come under pressure as last year’s rate hikes continue to work their way through the economy.

FED HIKES RATES AGAIN

As widely expected, the Fed continued its monetary tightening cycle, raising the federal funds rate by an additional 25 basis points bringing the target range to between 4.5%-4.75%, during the most recent FOMC meeting. The Fed further reduced its pace of rate hikes after a historic year in 2022 that included four consecutive 75 bps rate increases and one 50 bps rate hike in December.

Bond markets have rallied to start the year as yields on US Treasuries have declined. We expect the Fed to hike rates an additional .25 basis points in March and potentially again in May and then pause through the end of the year. This policy forecast assumes the US economy remains resilient, as we expect. We think the move in US Treasuries yields is overdone and will likely move higher in 2023.

The labor market remains tight, with the economy adding 200,000 jobs a month. While job growth has slowed, it remains supportive of economic growth. Wage growth has also slowed, but there is not yet enough slack in the labor market to warrant a pivot in Fed policy.

Chairman Powell confirmed this policy outlook stating, “we are talking about a couple more rate hikes to get to the level we think is appropriately restrictive” and “I don’t see rates coming down (this year)” during his press conference remarks. The guidance provided by Chairman Powell has contrasted strongly with the forward market’s expectations that are predicting that the Fed will only hike rates by 25 bps once more and then cut rates twice late this year (and further in 2024) on the expectations that the economy will fall into recession. Powell continued in his remarks, “there is a difference in perspective by some market measures on how fast inflation will come down. We will have to the see…I have a different forecast, but our forecast is that it will take some time and patience, and we will need to keep rates higher for longer”.

The ultimate path for rates this year is uncertain, but it is important to heed these words, “don’t fight the Fed.”

GOODS AND SERVICES TELL TWO DIFFERENT STORIES ABOUT INFLATION

First, let’s describe goods and services and how they relate to economic output. Goods are tangible items that are produced and sold. They are physical products such as automobiles, clothing, and electronics or raw materials and they can be stored and transported. Their price in the market determines their value.

On the other hand, services are intangible and typically performed by people for other people or organizations. Services include healthcare, education, financial services, and transportation. Unlike goods, services cannot be stored or transported and must be provided in real-time. The value of services is determined by the demand for them and the skills of the service providers.

As we know, the COVID-19 pandemic significantly disrupted economic activity in goods and services globally, and to mitigate the economic fallout, many governments engaged in massive fiscal stimulus programs. Unfortunately, these massive spending programs led to a steep surge in goods consumption, and industrial production could not to keep up with the shift in demand, ultimately leading to steep inflation in the price of goods (see chart right).

During the pandemic, the consumption of services fell dramatically. However, it only started slowly recovering as public mobility improved, vaccines became widely available, and overall COVID concerns moderated with increased therapeutics, additional research, etc.

As we have discussed, the Federal Reserve raised interest rates aggressively in 2022 to moderate the pace of inflation. But as monetary conditions tightened, supply chain issues declined, and some companies with once-depleted inventories had too many goods! As a result, we are now seeing significant declines in goods inflation, while inflation for services continues to remain strong as you can see in the chart right.

The service sector is significantly larger than the goods-producing sector accounting for 80% of US GDP according to data from the Bureau of Economic Analysis. Therefore, until the Fed sees a meaningful slowdown in service inflation, they are unlikely to pivot from their current monetary policy stance of bringing inflation down to their stated 2% target.

TAX REPORTS

For most Schwab account holders, your 1099-Composite statement will be available by mid-to-late February. For those with distributions from your retirement accounts, you should have already received a copy of your 1099-R. All tax reports can be accessed electronically via           SchwabAlliance.com when they become available. Don’t hesitate to contact us if you need help or assistance accessing these documents. In addition, if you’d like us to forward any tax-related documents to your CPA or tax preparer, we are happy to do so!

CHART OF THE MONTH

In fiscal year 2022, the federal government had a $1.4 trillion deficit. 
Interest payments totaled $480 billion in 2022 on a national debt of $31.4 trillion