Written by:  Mutsumi Kagawa (Chief Global Strategist, Economic Research Institute of Rakuten Securities)

(03/02/2023)

1. S&P 500 passed FOMC to new year-to-date high

There was profit-taking this week ahead of several events such as the FOMC (Federal Open Market Committee), employment statistics and earnings announcements of major high-tech companies. After the FOMC, market sentiment improved, and the S&P500 Index and the Nasdaq Composite Index set new highs since the beginning of the year (February 1). The Federal Reserve Board (FRB) decided to raise interest rates by 0.25% at the FOMC which held on January 31 and February 1. The interest rate hikes were in line with the average market forecasts in advance, and the rate hikes were reduced for the second consecutive meeting (0.75% → 0.50% → 0.25%). At a press conference immediately after the meeting, FRB Chairman Powell said, “Disinflation process has started.” It is a positive sign for the market, which had been looking forward for a hint to halt rate hikes. The bond interest rates fell, and stocks surged. Chart 1 shows changes in US stocks (S&P 500), policy interest rate (target upper limit for FF interest rate), short-term bond interest rate (2-year bond yield) and long-term bond interest rate (10-year bond yield) since the beginning of the year. The level of bond interests indicates that the FRB is going to halt the rate hikes. Regarding financial results announcements in last year October-December, which attracted a lot of attention from the market, 205 major companies (from the 500 companies that make up the S&P 500 index) announced their financial results with slight increases in sales and profits (described later) in overall, which is a major factor supporting the stock market. However, the continued monetary tightening by central banks and the slowdown of the economy and business performance may cause investors to stay cautious every so often. For the time being, we need to pay attention to stock price fluctuations.

2. The unemployment rate will gradually rise as the US economy slows down

It is strongly believed that the rate hikes reduction by FRB reflects the slowdown in the inflation rate and the economic outlook. Chart 2 shows the US real GDP growth rate (quarter-on-quarter annualized rate) and unemployment rate (actual and economist forecasted average) by quarter. Last year’s 4th quarter real GDP (preliminary figure) was announced on January 26 recorded an increase of +2.9% year-on-year on an annualized basis, exceeding the average market forecast (+2.6%). However, personal consumption, housing investment and net exports have slowed down… In general, economists predict that real GDP growth will slow to +0.1% in the 1st quarter of 2023, followed by slight negative growth (technical recession) in the 2nd and 3rd quarters, and returning positive growth from the 4th quarter onwards. The unemployment rate, a lagging indicator of the economy, is likely to increase gradually in tandem with the economic slowdown. The US economy is expected to make a soft landing after hitting the bottom of the mild recession in the middle of the year.

On the other hand, let’s check the current corporate performance. According to data compiled by Bloomberg as of February 1, 205 of the 500 major US companies that announced their financial results for the 4th quarter (mainly for the October-December quarter) reported a 5.8% year-on-year increase in total sales, and total earnings grew by 0.2%. They have exceeded market forecast by 0.9% and 2.1% respectively (positive surprise). Overall, it gives an impression that “the financial results were not as bad as expected”. However, a cautious tone is noticeable in the guidance (earnings forecast) for this fiscal year (January-March quarter) and this year by company. Last year’s decline in stock prices has already factored in a considerable slowdown in performance. However, we cannot deny the possibility that corporate performance may further deteriorate depending on the extent of the economic slowdown. The market will pay attention to when and to what extent the stock market will consider for the bottoming out of the economy expected in the middle of the year and the recovery toward next year.

3. Looking back at the early 1970s – Inflation and stock prices are “inversely correlated”

According to the policy interest rate forecast (immediately after the FOMC) calculated in the futures market, the FRB is expected to “stop” raising interest rates at about 5% in mid-2023, and gradually lower interest rates from the second half of the year to 2024. The market believes that the FRB’s “pivot” (policy change) is near, due to the slowdown in inflation and the economic deceleration resulted from the cumulative effect of the interest rate hikes since last year. When inflation is peaking out, long-term bond yields, which have been moving below the policy rate, may fall further if the economic slowdown continues. Lower long-term bond yield improves relative valuations for stocks, and the recovery in stocks (lower volatility ≒ lower fear index (VIX)) may lower stock market risk premiums.

Inflation (high prices) triggered by soaring energy prices during the early 1970s (the 1st oil crisis). Chart 3 shows changes in the inflation rate (CPI year-on-year growth) and stock prices (S&P 500 index) from 1972 to 1976. The FRB tightened monetary policy to curb the rising inflation rate from 1973, which forced stock prices to fall sharply. However, the stocks bottomed out before inflation peaked at over 12% at the end of 1994. After that, the stock price recovered with an “inverse correlation” with the movement of the inflation rate which is decreasing. This year, I expect US stocks will recover towards the 2nd half of the year as the market assesses slowing inflation, stable interest rates and a soft landing for the economy.