Let’s Make a Deal
In the television game show Let’s Make a Deal, contestants were offered something of value and given a choice whether to keep it or exchange it for a different item. That other item, which may have a lower or higher value than the original item, remained hidden, often behind a door, until the choice was made. People planning for retirement are also faced with choices but often have the luxury of generally knowing the potential outcomes of their decisions. However, the markets are much less predictable and without a carefully planned strategy, investing can become a game of chance.
The optimism present in the stock market to begin the year faded this past week. Despite a Producer Price Index (PPI) report showing inflation slowing more than expected, Federal Reserve officials indicated they plan on continuing to raise interest rates, sending markets lower in the middle of the week. Retail sales for December were softer than expected, showing the holiday shopping season may not have been as robust as hoped. Longer term bond yields moved lower on the weakness since this could be a signal of slowing economic activity, while shorter term rates moved slightly higher in anticipation of the Fed continuing to raise rates.
Now that 2023 is well underway we have some idea of different scenarios which might play out in the markets this year. Even though markets can be very unpredictable and unanticipated events are always bound to occur, the varying outcomes we are now facing seem to be broader and more differing than most years. This year, not unlike most others, the focus is firmly on inflation, interest rates, a potential recession, and corporate earnings, all of which are very much intertwined and are likely to impact the others. What are these scenarios? What might it look like behind these doors?
Inflation has moderated considerably since reaching 40-year highs last year but remains well above the levels experienced over the past several decades. Last week’s lower than expected PPI report, including a month-over-month decrease, is giving some credence that inflation is dropping faster than anticipated and perhaps the Federal Reserve has already achieved their objective of combating rising prices with seemingly increasing odds they will be able to pull off a soft landing. But fear remains they have, or will, overshot the target with monetary policy that is too restrictive. Another belief is that lower prices are the result of demand destruction, meaning the economy is slowing so there is less demand for goods and services. This would be a bad sign for the economy and may signal we are indeed headed for a recession, if we are not already in the midst of one.
The Price is Right
Since a large number of economists are predicting a recession at some point this year or next, it seems hard to believe this has not already been priced into the market, but the question remains to what extent? Markets tend to be forward looking, often pricing in future events quarters in advance. An expected recession, even if it does not come to fruition, may ultimately have the same impact as a real recession. Recently we have seen the pace of layoffs accelerate with statements from companies conducting layoffs that workforce needs are shifting as a result of changing economic conditions, interpreted to mean they are seeing a slowdown in their businesses. Consumer spending seems to be slowing, likely due to fears over deteriorating economic conditions including job insecurity and lower levels of household savings. Despite signs of a softening in economic conditions, the Federal Reserve is expected to continue raising interest rates and statements from officials indicate they plan on keeping rates “higher for longer.” Restrictive monetary policy makes borrowing more costly, stymying growth.
Now that we are in the middle of earnings season, one theme has prevailed – expectations are being lowered. There has even been a change in analysts’ estimates over the past few weeks from year-over-year growth to year-over-year declines lasting throughout 2023. This probably does not come as too large of a surprise since talk of a recession and economic slowdown have been prevalent over the past several months. And similar to a recession, how much have lowered earnings expectations already been priced into the markets? It probably depends upon the extent of the downward revisions. A certain amount has likely already been priced in so if earnings do not fall as much as expected it could provide a positive catalyst for the stock market, and of course the opposite is also true – if earnings decrease by more than expected it could be a bad omen. Currently, stock valuations, chiefly measured by price-to-earnings ratios, are near historical long-term averages. If earnings decrease, stocks may be viewed as being expensive on a relative value basis, meaning the market could adjust and we see stock prices fall. While there are a lot of questions in the market and the short-term outlook looks rather gloomy, we remain very optimistic on longer term market prospects.
Some of the mega-cap names report earnings this coming week, putting us firmly into the heart of earnings season. These results will likely help set the tone for the remainder of the year. The Fed’s preferred measure of inflation, Personal Consumption Expenditures (PCE) will be released on Friday, but we do not anticipate it change the action of the Fed at their upcoming meeting next week. In addition to inflation, PCE also measures personal spending and with the weaker than expected report on retail sales, sluggishness in overall spending would be viewed as indication the economy is indeed slowing.
Markets can be very unpredictable and unanticipated events are always bound to happen. We do not know exactly what the future will bring, but we can at least position for those scenarios most likely to occur. Whatever appears behind each door should not cause concern but rather should be viewed as an opportunity. Do not hesitate to call us to discuss your individual situation to ensure you are positioned appropriately and not leaving your retirement to chance.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
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