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Torsten Asmus
The SPDR S&P 500 ETF (NYSEARCA:SPY) has continued its remarkable advance since the start of 2023 but could face a resurgent Fed committed to taming persistently high inflation rates.
Yesterday's CPI release by the Bureau of Labor Statistics showed a higher-than-expected print on both the headline and core metrics. As a result, market strategists are locked in a debate on whether the Fed should take heed of yesterday's readings to push toward its median Fed funds rate (FFR) target of 5.1%.
Accordingly, the market seems to have priced in an increased likelihood of at least two more 25 bps rate hikes moving forward, as inflation has proved persistent despite the Fed's record hiking cadence.
However, the debate is still open as to whether an earlier-than-expected pivot could be possible after a higher-than-expected inflation print.
Strategist Edward Yardeni cautioned in a commentary on February 13 that financial conditions are still tight but not debilitating. He articulated:
Data relevant to financial conditions reveals them as tight, but in a good way—tight enough to bring inflation down without a recession but not tight enough to provoke a credit crunch that results in a recession. - Yardeni Research, 13 February 2023 morning brief
Economists John Greenwood and Steve H. Hanke, who predicted the high inflationary outcome and its persistent behavior due to the Fed's pandemic bailout, also urged the Fed not to overtighten further.
They argued in a recent WSJ opinion piece that inflation is on a downward trajectory, and the boost in the M2 money supply has continued to fall markedly. Accordingly, it has "[declined] at an annualized rate of 3.2% in the past nine months, which is the steepest adjustment in money-supply growth in postwar US history."
As such, the economists articulated that "the excess money balances have already declined to only 11.8% greater than normal, and that slight bump could dissipate entirely by mid-2023." Therefore, we believe the Fed needs to be cautious as macro and more granular indicators/surveys from the above sources highlight the increased risks of a botched policy move by tightening further and holding it higher for "too long."
Such a scenario could lead to a deeper-than-anticipated recession that could prolong the pain for investors as equity valuation multiples will likely need to compress further.
Hence, Fed Chair Jerome Powell & the FOMC must tread carefully here by not over-relying on backward-looking data but focusing on forward-looking information to undergird their decision-making process.
5Y Breakeven inflation rate % price chart (weekly) (TradingView)
The Fed must consider that "consumers' outlook for inflation fell to the lowest since October 2020." Also, the growth in average hourly earnings has slowed to 4.4% in January, down from December's revised 4.8% uptick.
Moreover, the 5Y breakeven inflation rate is still well below its March 2022 highs, suggesting that medium-term forward expectations are anchored well below the current CPI numbers.
As such, the market still expects that the Fed's monetary policy will prove its efficacy. However, the Fed needs to give it sufficient time to work through its lags and not push the economy and market off the cliff.
The most crucial sector in the SPY: Technology, has performed well. Accordingly, the Technology Select Sector ETF (XLK) surged nearly 30% from its October lows, inching closer to its August highs, outperforming the S&P 500.
Also, the Consumer Discretionary Select Sector ETF (XLY) has recovered more than 25% from its October lows through its early February highs, outperforming the SPY.
Investors need to consider the risk-on momentum that has driven the broad market surge is not consistent with a bear market continuation. Also, money managers have covered their short bets extensively, moving back into a more neutral stance, in line with historical metrics.
Does the market expect the Fed to tighten further and cause a steeper recession?
Based on the SPY's price action, as discussed in our early January update, the market had already anticipated a mild recession at the S&P 500's October lows.
With that in mind, we believe market operators are not expecting the Fed to move "recklessly" despite acknowledging that two more rate hikes could still be necessary to set the stage for the Fed's 2% price stability goal.
However, we believe the market has already moved past the possibility that the Fed will not likely push too hard and cause a worse-than-expected recession. We are still in line with that thesis, as financial conditions remain tight, as discussed earlier, no matter what the media has reported.
Notwithstanding, the SPY has likely reached a line in the sand where a near-term consolidation and pullback will be constructive.
Investors are encouraged to leverage pullbacks for dip-buying opportunities to load up and not fear catching falling knives.
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