by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with the market’s reaction to Wednesday’s economic data. Next, we discuss why central banks are now pushing for smaller rate hikes. We end the report with our thoughts about the recent developments in tech and crypto.

A Softish Landing: Poor economic data and hawkish Fed comments led to a sell-off in equities.

• Retail sales figures showed that consumer spending declined for the third consecutive month in December. Meanwhile, industrial production data showed that manufacturing activity also waned over that period. The weak figures show that the Fed may not be able to lower rates before the economy enters recession, which would have been known as a “soft landing.” On Wednesday, Cleveland Fed President Loretta Mester and St. Louis Fed President James Bullard stated that the Federal Reserve was not finished raising rates and would need to keep rates tight for some time to bring down inflation. Therefore, the likelihood that the Fed will keep rates higher, even during a downturn, is elevated.
• The weak economic data spooked investors who previously believed that the economy may have averted a recession. As a result, the market responded negatively to the dimmer outlook for the economy. The S&P 500 closed down 1.6% from the prior day. Meanwhile, bond prices jumped, and the 10-year Treasury yield plunged to a 4-month low of 3.368%.  The market reaction was likely a combination of investors looking to lock in early 2023 gains and secure bonds while interest rates remain relatively high.
• In our view, equity investors and bondholders have two opposing views on the Fed. Stock traders believe that Fed Chair Jerome Powell will cave once the economy starts to sputter. Meanwhile, bond traders are convinced that Powell will keep rates elevated even as the country falls into recession. Although it isn’t clear who’s right, the difference will likely dictate how the market performs throughout the year. If equity traders are right, stocks should have strong performance as the market has likely priced in the worst of a recession. However, if bondholders are correct, the slump in equity prices could worsen. At this time, we believe that investors should take a wait-and-see approach before making major adjustments to their portfolios.

The Central Bank Shuffle: Although the Fed insists that it will continue to raise rates, there are growing expectations that it will decrease the size of its hike at its next meeting.

• Dallas Federal President Lorie Logan, a voting member, added to the chorus of calls for a downshift in rate hikes beginning at the Federal Open Market Committee meeting next month. On Wednesday, she argued that a slower pace of hikes could reduce interest rate uncertainty, which should alleviate financial conditions. Although she later added that the Fed should ultimately settle rates at a higher level than originally anticipated, her comments did seem to fall in line with market expectations of a 25 bps hike at the Fed’s February meeting. The CME FedWatch tool shows that there is a 95% chance that the central bank will raise its target range from 4.25%-4.50% to 4.50%-4.75%.
• Talk of a possible moderation in Fed tightening has helped support foreign currencies and has provided other central banks with more flexibility to set rates. After hitting parity in 2022, the GBP and the EUR have rallied strongly against the USD.  Meanwhile, the JPY has skyrocketed following the Bank of Japan’s decision to lift its yield cap on 10-year Japanese government bonds. The three currencies are hovering near seven-month highs, which reduced pressure on these countries’ respective central banks to tighten aggressively in order to defend against a strengthening dollar.
  • Despite being one of the strongest-performing assets last year, the USD, as tracked by the DXY index, is down 1.3% to begin the year, which is worse than the poorest-performing asset class in the S&P 500.
• Other central banks are now following the Fed’s lead in moderating their tightening. Despite guidance from European Central Bank President Christine Lagarde that borrowing costs will be lifted in 50 bps increments over its next two meetings, there is talk that the ECB could slow hikes as soon as March. Meanwhile, the Bank of Japan’s decision to defy market expectations and not alter its policy on Wednesday has also added to speculation as to whether it plans to tighten policy anytime soon. The dovish shift from central banks should be beneficial to equities as it will prevent a further slowing of the global economy. However, we would like to caution that the mood may change if inflation returns due to China’s reopening.

Tech and Crypto Risk: As investors increase their appetite for risk, tech companies and crypto platforms struggle to find a path forward.

• The tech sector is headed for a reset as companies adapt to a higher interest rate environment. Microsoft (MSFT, $235.81) and Amazon (AMZN, $95.46) announced a combined 28,000 job cuts on Wednesday. The huge cutback in their workforce is related to the industry looking to reposition itself after years of robust growth. After suffering its worst yearly performance since the Great Financial Crisis, NASDAQ is now up 5.5% on the year, nearly twice that of the S&P 500. The rebalance in tech could position the sector for stronger growth when economic growth starts to pick back up.
• Meanwhile, the fallout from crypto continues to spread. On Wednesday, digital currency platform Coinbase (COIN, $50.21) announced that it was halting operations in Japan. Additionally, reports claim that crypto lender Genesis is preparing to file for bankruptcy. The negative developments in crypto reflect the growing uncertainty surrounding digital assets and suggest that the currency still has many risks. Bitcoin dropped below $21,000 following the development but still remains up 25% on the year.
• The end of zero-interest rates monetary policy has forced tech companies and crypto to restructure their businesses. This should make firms leaner and more profitable as well as create a more viable digital currency market in the long run. However, the recent turmoil suggests that there is still some market skittishness toward riskier financial assets. Investors should remember that despite speculation of a soft landing, there is still time for things to turn awry. As a result, investors should remain cautious and complete their due diligence before investing in riskier elements of the market.

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