Game of Chicken
The game of “Chicken” is a model of conflict for two players with the principle being that the ideal outcome is for one player to yield, which the involved parties try to avoid out of pride for not wanting to look like a “chicken” or coward. This game has its origins in a game in which two drivers drive toward each other on a collision course: where one driver must swerve to avoid catastrophic consequences, at the expense of being called a chicken. As of now, the outlook of the markets and the Federal Reserve are at odds, with future actions seemingly on a collision course. In this case, neither needs to necessarily back down but can both be right? Will one of the two need to change course?
Equities were higher last week with the major indices continuing to rally off their 2022 lows. Big tech has a strong week despite blemishes late in the week from disappointing earnings reports from Apple, Amazon, and Alphabet (Google). Continued evidence of disinflation, a resilient labor market, and the Fed nearing the end of its rate-hiking campaign served to bolster expectations for a soft landing ahead and provide continued thrust for the equity markets.
The Fed raised interest rates by one-quarter of a percent as had been widely expected. There were few changes to the post-meeting statement, including ongoing rate increases remaining appropriate but shifting reference to the future from discussing the “pace” of hikes to their “extent.” Fed Chairman Powell’s remarks post-meeting including using the term disinflationary multiple times and indicated the Fed’s base case is for a soft landing. The meeting seemed to cement market expectations for rates to top out at their March meeting, with the markets staging a rally in its wake. But signals from the Fed indicate even if they do stop raising rates, they plan on keeping them where they are and not cutting rates anytime year. And this is what puts us on a collision course, as the markets are pricing in rate cuts in the latter half of the year.
When the term “The Fed” is used, it is generally in reference to the Federal Open Market Committee (FOMC), the entity within the Federal Reserve that sets monetary policy for the central bank, including interest rates. Members of The Fed are often considered to be “hawkish” or “dovish”, either in favor of tighter or looser monetary policy, respectively. In economics the game of chicken is often referred to as the hawk-dove game where each side can either be an aggressor (hawk) or more passive (dove). If both sides are aggressive, or hawks, they will fight until one is injured and the other wins. If only one side is hawkish and the other dovish, the hawkish side will win, but if both sides are dovish, there will be a tie and each player receives a payoff lower than the profit of a hawk defeating a dove. Similarly, even though the message from the Fed of interest rates being higher for longer seems at odds with what the markets are currently pricing in, the outcome could be somewhere in the middle.
The slightly more dovish tone from the Fed after their meeting may have been complicated by the Friday release of the employment numbers which were considerably better than expected with the unemployment rate falling to 3.4%, its lowest level since 1969. The increase in payrolls seemed to take the market by surprise and did spark a vigorous conversation about how much of the deviation from expectations was due to seasonal adjustment factors. Despite this debate, the report did provide evidence the labor market has remained resilient despite the Fed’s hiking campaign, which may be supportive of the soft-landing thesis. But it also heightened market expectations for the Fed to raise interest rates even higher before pausing.
The Fed meeting and employment reports overshadowed the fact that we are still in the midst of earnings season. Some 70% of reports thus far have beaten analysts’ expectations, giving thrust to the markets. However, the blended negative growth rate of an aggregate of S&P 500 companies’ earnings is well below what was expected at the end of the quarter. The market has been rewarding earnings beats more than average, lending further support to the idea that despite recent worries about earnings resilience, the bar has already been lowered.
There is likely to be added attention to remarks made by members of the Fed in coming weeks after the surprisingly robust January payrolls report. Probabilities of quarter point rate increases at the upcoming March and May Fed meetings increased considerably after the report, but we will caution there is a significant amount of data to be released in the interim, so we are not counting on anything at this point. The main driver of market action this coming week will most likely be the continuation of Q4 earnings releases. It is not until next week that we will see a deluge of economic data, most notably the CPI and PPI reports.
Widely diverging forecasts for the market continue to be a common theme, with some thinking the worst is behind us and others being of the belief that we are on the precipice of a recession which will send markets lower. We like to advise investors to be prepared to weather the storm, no matter what the markets bring, as well as maintain a long-term perspective. The term “volatility” is being used frequently, but as a reminder volatility can either be to the downside or upside and therefore is not always a bad thing for those invested in the markets and able to tolerate price swings. If you are playing a game of chicken with your retirement, you probably ought to rethink your strategy since this is something where you only get one chance, and the outcome will affect your lifestyle for the duration of your golden years. Call us if you would like help feeling more confident and ensuring you are not on a collision course with disaster.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
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