Written by: Benjamin Bimson CIMA®, CMT® / CIO, Trek Financial
Last week was certainly busy in the markets, with two themes playing key roles in the potential direction of markets this year. The first being the Fed. The Fed hiked interest rates a quarter of a percentage point last Wednesday, there are questions about how many rate hikes will follow, when the Fed will pause interest rate hikes, and some speculation about changes in policy to monetary easing. The second theme that is moving market data is the U.S. Bureau of Labor Statistics monthly employment report. The report showed a larger than expected increase in non-farm payroll employment. And while very low unemployment rates are generally a good thing, it did make stock markets nervous.1,2
In order to understand why the Fed’s moves and labor data has so much impact on the economy and investment markets, it’s important to understand the macro-environment that we are in. Historically speaking, rallies within bear markets have happened, and some have even lasted for a while. This is especially true after a prolonged timeframe where bad performance washes out investors that are not long-term focused. The rally that took hold most recently seems largely based in a belief or hope that the Fed is close to ending the rate hikes and could possibly engineer the second ever “soft-landing” in the economy.4 While this sounds hopeful, soft landings (when policymakers get “everything perfect”) are difficult to achieve. In fact, the Fed has actually only engineered one soft landing in the past, and that was back in 1994. Soft-landing is when policymakers get everything perfect, which can be difficult to achieve.3
This brings us to the fundamental question about our current economy: Are we headed for recession following the attempt to bring down inflation or are we going to experience the second soft-landing? The implications for markets in the next six months are likely conditioned on this. It has vast implications for whether more market volatility lays ahead or whether the worst is behind us.
In order to have a soft landing, we need to see a few things develop. First, we need to have inflation continue to decline. According to the Fed statements, they are being very clear that they are looking for sufficient economic tightening to ensure that inflation pressure subsides. In order to do that, labor needs to tighten (fewer jobs) and slow down demand for goods and services. Therefore, when labor reports come in higher than expected, it indicates that the economy is not yet being fully impacted by the Fed tightening. That would go against the market anticipation that the Fed will be able to be less aggressive later in 2023. This puts continued market rallies at risk.
Unemployment rates are directly correlated to labor reports and therefore will continue to be important in 2023. Depending on what happens, the Fed is likely to continue to need to be hawkish rather than more accommodative. The longer the Fed is hawkish to fight inflation, the less likely a soft landing becomes.
This chart illustrates how unemployment tends to spike in the event of a recession. Source: Ned Davis Research Group
Since the market tends to be a barometer of investor sentiment about the future, it reacts strongly to key datapoints. Labor reports, Fed meetings, Fed speeches, and inflation reports are going to be themes that drive markets in 2023. Is this the year of the second Soft-Landing? Is 2023 the year of the next recession? Is 2023 the year of inflation becoming a mere memory? No matter what the answers to these questions end up becoming, we need to remain able to adapt to the dynamic environment.
Having a well- grounded strategy to navigate these times is crucial to keeping a calm mind in a time when there are very divergent possibilities. On the one hand, we need to be able to fight the fear of missing out. On the other hand, betting on a soft-landing is not statistically a good bet. In the history of the Fed, they have not had many soft-landings and they have been extremely clear that they will do what is necessary to bring inflation down. On the other hand, if they are able to pull off the perfect balance, markets will be very happy. Either way, 2023 is sure to be another historic year!
- Press Release: Federal Reserve issues FOMC statement. 2/1/23. https://www.federalreserve.gov/newsevents/pressreleases/monetary20230201a.htm [2/6/23]
- Employment Situation Summary. U.S. Bureau of Labor Statistics. 2/3/23. https://www.bls.gov/news.release/empsit.nr0.htm [2/6/23]
- Alan Blinder on Landings Hard and Soft: The Fed, 1965-2020. Princeton University Bendheim Center for Finance Webinar Transcript. 2/11/22. https://bcf.princeton.edu/wp-content/uploads/2022/01/Transcript-1.pdf [2/6/23]
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