Broker Check
Schwab Market Perspective

Schwab Market Perspective

March 08, 2023




The transition between winter and spring is often contradictory. Green shoots push through snowdrifts, while spring-like warm days revert to cold nights. The economy is in a similar transition, as central banks' efforts to chill inflation face new signs of economic growth.

The big question, of course, is whether the Federal Reserve and other central banks will find a way to subdue inflation without causing a recession. As with the weather, though, the signs are frustratingly muddled. Corporate earnings, for example, have weakened, while other evidence suggests global manufacturing activity is actually strengthening. At the same time, longer-term Treasury yields have risen as the Fed has signaled it's not done raising interest rates just yet.

The absence of clarity can be unsettling. Here's how we see things shaping up.

U.S. stocks and economy: Mixed signals

Two measures from the labor market underscore this contradictory moment. Wage growth is slowing but remains fairly high. However, whereas growth in average hourly earnings—a comparatively noisy measure of workers' gross pay—has slowed relatively quickly, the Atlanta Fed's Wage Growth Tracker—which measures the median percent change in workers' hourly wages—hasn't moved as much. This presents a problem for the Fed, because such "sticky" wage growth could pose inflationary risks. If signs of further weakening don't appear, the Fed may decide to push short-term interest rates even higher.

Median wage growth has remained "sticky" even as average hourly earnings declined






Any further tightening in policy might compound pressure building from a weaker corporate earnings backdrop. The share of companies in the S&P 500® Index reporting quarterly earnings above analysts' average estimates—known as the "beat rate"—has fallen in the reporting season for the fourth quarter of 2022. Not only that, but the companies that have beat estimates are doing so by the smallest margins since the 2007-2008 financial crisis.

Corporate earnings are not beating expectations as much as they used to



We think profit margins are likely to deteriorate further, which could pose a risk to the stock market this year. For that reason, we suggest investors who actively choose stocks focus on companies that have maintained—and still expect—strong profit margins.

Fixed income: Is the bond bear back?

Treasury yields have rebounded from their lows in recent weeks because the message from Fed officials is clear: "We're not done hiking rates. We will keep at it until inflation comes down."

The Fed's messaging combined with stronger-than-expected labor market data have renewed concerns that a bond bear market, with falling prices and rising yields, may be coming. We don't think that's likely. Here's why:

1. The Fed has allowed the yield curve to remain inverted, with longer-term yields below short-term yields. In past cycles, intermediate- and long-term bond yields have tended to stay low or keep falling until the Fed is near the end of its rate-hiking cycle—and bottom out at the onset of recession. Each recession is different, but the historical pattern has been consistent.

Where does that leave us now? Estimates of the terminal rate for interest rates are rising, while the Fed's rate hikes continue to push the yield curve to more steeply inverted levels. As a result, an inverted yield curve is likely to be a key feature of the Treasury market in 2023.

The two-year/10-year Treasury yield curve is inverted


There are two ways that the Fed could push long-term yields higher—either by abandoning its inflation-fighting target or by changing its quantitative tightening plans to include outright sales of bonds. We don't see either one happening. Nor does it appear that the Fed is targeting a level of long-term rates. The central bank seems fine with the curve remaining inverted.

2. Inflation has been declining, and inflation expectations are moderate. The Fed has recently indicated concern that inflation in the service sector (excluding housing) is stubbornly high. However, weakening consumer spending suggests price growth will continue to slow.

Inflation appears to have peaked

It may take some time for inflation to fall further, but we would need to see stronger demand for inflation to start moving higher again. With the trend in personal consumption expenditures declining and consumer credit growth slowing, we don't see another demand-driven bout of inflation.

Personal consumption spending has slowed


Meanwhile, market- and survey-based indicators suggest inflation expectations remain well anchored. Treasury Inflation-Protected (TIPS) breakeven levels are hovering in the 2% to 2.5% region, while the University of Michigan survey shows consumers see inflation averaging less than 3% in five to 10 years.

Consumers expect inflation of less than 3% over the next five-10 years


 

3. Credit standards have tightened. Banks have made it harder and more expensive for consumers and businesses to obtain financing. The Federal Reserve's Senior Loan Officer quarterly opinion survey has shown significant tightening in both consumer and business lending since mid-2021.

Lending standards have tightened since 2021

Not surprisingly, consumer credit growth is slowing. With rates for mortgages, credit cards, and auto loans rising, the Fed's tightening policy is on track to slow consumption.

Consumer credit growth has slowed

After a steep drop in intermediate- to long-term bond yields over the past few months, the recent rebound wasn't too surprising. Short-term yields are likely to continue rising over the next few months as the Fed keeps hiking the federal funds rate, its benchmark lending rate. However, we don't see 10-year Treasury yields moving to new highs above 4.35% in this rate-hike cycle.

Global stocks and economy: Green shoots?

The global economy, meanwhile, may have hit an inflection point amid signs manufacturing activity is crawling from its trough.

Global manufacturing has lagged in the post-pandemic era as inventory shortages turned to gluts last year, even as global demand for services (like travel and entertainment) boomed. In fact, according to purchasing managers' index (PMI) surveys of manufacturing business leaders, global exports of manufactured goods, and revenues of manufacturing firms, factory output actually fell into a recession at the end of last summer.

Now, however, signs have started to emerge that manufacturing may be bouncing back as surplus inventories are drawn down. Indeed, activity in leading industrial-driven economies like China and Germany is picking up, with the China PMI and German Ifo Business Climate Index both having recovered from lows reached in September-October 2022. Globally, manufacturing output is still weak, but forward-looking expectations and components such as new-orders-to-inventory ratios may be signaling the start of a rebound.

Based on new-orders-to-inventory ratios, manufacturing may be poised to rebound

Growth in manufacturing would be a good sign for the global economy. Comments by global business leaders during the earnings season suggest healthy demand in China could help draw down excess inventories, allowing brands to pare promotions and boost output.

The tradeoff, of course, is that such a recovery could prevent central banks from the enacting the interest rate cuts that the market seems to expect later this year. After forecasting further hikes for the first half of this year (see the orange columns in the chart below), the futures market has priced in rate cuts beginning in the second half of the year (blue columns) for many of the major central banks.

Market sees hikes in first half of the year, then cuts in second half

It would likely take more global economic and labor weakness, combined with a more rapid decline in price pressures, to prompt such a reversal in policy this year. Rate cuts may not be needed to stimulate economic activity if manufacturing activity is already strengthening.

If economic green shoots do take root, stocks that tend to benefit from rate cuts, such as growth stocks, could suffer, while cyclical value stocks may fare better.

 

Kevin Gordon, Senior Investment Strategist, contributed to this report.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk including loss of principal.

Forecasts contained herein are for illustrative purposes only, may be based upon Proprietary research and are developed through analysis of historical public data.

Futures trading involves a high level of risk and is not suitable for all investors. Certain requirements must be met to trade futures. Please read Risk Disclosure Statement for Futures and Options before considering any futures transactions.

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

 Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

"Green shoots" is a term used to describe signs of economic recovery or positive data during an economic downturn.

Performance may be affected by risks associated with non-diversification, including investments in specific countries or sectors. Additional risks may also include, but are not limited to, investments in foreign securities, especially emerging markets, real estate investment trusts (REITs), fixed income and small capitalization securities. Each individual investor should consider these risks carefully before investing in a particular security or strategy.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see schwab.com/indexdefinitions

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Read about privacy at Schwab at www.schwab.com/privacy.

The above mentioned firms and their employees are not affiliated with or employees of Schwab unless otherwise noted. They should not be construed as a recommendation, endorsement of, or sponsorship by Schwab. The views expressed are those of the third party and are provided for information purposes only. Experiences expressed are no guarantee of future performance or success and may not be representative of you or your experience. 

Schwab does not provide investment planning, legal, regulatory, tax, or compliance advice. Consult professionals in these fields to address your specific circumstances.

For informational purposes only. Third party trademarks are the property of their respective owners and used with permission. Third party firms and their employees are not affiliated with or an employee of Schwab.

Information included on this site is intended to be an overview and is subject to change. Experiences expressed by advisors may not be representative of the experience of other advisors and are not a guarantee of future success.

Schwab Advisor Services serves independent investment advisors and includes the custody, trading and support services of Schwab. Independent investment advisors are not owned by, affiliated with or supervised by Schwab.

© 2023 Charles Schwab & Co., Inc. ("Schwab") All rights reserved. Member SIPC.