It's the economy that just won’t die.
Even after a series of rate hikes by the Federal Reserve (Fed) totaling 4.25% over the past 12 months, along with other monetary tightening policies, the economy has continued to grow at a healthy clip.
Gross domestic product (GDP) grew by an annualized rate of 2.9% in the 4th quarter of 2022, according to the Bureau of Economic Analysis (BEA). That followed an unexpectedly strong 3rd quarter increase of 3.2%. GDP ended 2022 with a total increase of 2.1% after a slow start. Growth was driven by increases in private inventory investment, consumer spending, federal, state and local government spending, and nonresidential fixed investment, offset by declines in single-family home construction and exports.
Employment growth exploded in January, with employers adding more than half a million new workers. The unemployment rate dropped to just 3.4%, the lowest level in more than 50 years. And “help wanted” signs continue to proliferate, with job openings rising by half a million in December to a total of about 11 million openings, according to the Fed.
Personal consumption expenditures (PCE) declined 0.2% in December after a 0.1% drop in November, according to the January 27 BEA report. The PCE price index, which is an indicator of inflation, was up just 0.1% over the previous month, and up 5.0% from 12 months earlier. That was the lowest reading since October 2021. Excluding food and energy, prices were up just 4.4% for the 12-month period through December, a 14-month low.
The manufacturing sector continues to be adversely affected by the Fed hikes, with activity declining in January for the third straight month after 30 consecutive months of growth, according to the Institute for Supply Management (ISM) report issued February 1. Only two of the 15 industries tracked by ISM reported growth in manufacturing activity in January – Transportation Equipment and Miscellaneous Manufacturing. According to the report, manufacturers have indicated that they have reduced activity in the 1st quarter of 2023 due to a slowdown in orders but are preparing for a strong second half of 2023. The report noted a couple of positive trends – improved delivery times for parts and supplies, which had been a major bottleneck coming out of the pandemic, and contracting prices for supplies for the fourth consecutive month.
Outlook: Some areas of the economy are responding to the Fed’s monetary tightening policies, with a slowdown in manufacturing and the housing market, tapering increases in the CPE price index, and diminishing corporate earnings expectations. But with solid 4th quarter GDP growth and a red-hot job market, the Fed may decide to take a more aggressive approach than anticipated in terms of rate hikes and other monetary tightening measures.
Investors should be prepared for higher interest rates for an extended period. Even after the rate hikes end, there is no indication the Fed will be in any rush to reverse course and begin cutting rates unless there’s an unexpectedly sharp downturn in the economy.
Although bond prices have staged a significant rally recently, and the prospect of near-term capital gains has diminished, the fixed income market now offers improved long-term income opportunities relative to the historically low yields of the past decade. Money market fund yields, which have been paying in the range of 4%, may continue to rise along with further Fed rate hikes.
Corporate earnings may continue to weaken in the short term, due to the impact of inflation on rising wages, corporate cost structures, and higher input costs.
In the equity market, technology stocks have already started to rebound after significant losses in 2022. Value stocks seem positioned for a relative performance advantage. Small cap valuations look attractive and could be poised to outperform later in 2023, as cyclical headwinds turn to tailwinds. Quality growth stocks could benefit from falling rates and a potential scarcity of growth options in a slowing economy. We expect market performance to stabilize later in 2023 or beyond.
U.S. stocks rally
The S&P 500® Index was up 6.18% in January, from 3,839.50 at the end of 2022 to 4076.60 at the January close, as investors reacted to some positive economic trends. The total return of the S&P 500 (including dividends) was 6.28%. (The S&P 500 is a market-cap-weighted index that represents the average performance of a group of 500 large capitalization stocks.)
The tech-heavy NASDAQ Index fared even better, as technology stocks began to rebound from a dismal 2022. The NASDAQ was up 10.68% for the month, from 10,466.48 at the close of 2022 to 11,584.55 at the end of January. (The NASDAQ – National Association of Securities Dealers Automated Quotations – is an electronic stock exchange with more than 3,300 company listings.)