Stocks tumble on hawkish Fed minutes, inflation data

Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks. – Warren Buffett

A hotter than expected inflation report and rising bond yields took their toll on the stock market last week as the Dow Jones Industrial Average fell for the fourth straight week and the major averages posted their worst week in 2023. After a strong January that saw the S&P 500 Index rise nearly 9%, the broad-based index has now given back more than half of the gain in February. Minutes from the most recent Federal Reserve meeting showed inflation was still well above the Fed’s 2% target as the labor market remains very tight and has contributed to higher wages and prices. While the Fed acknowledged that the inflation data over the past three months has shown a notable decline, more evidence of progress was needed to be confident that inflation was on a sustained downward path. After the most recent 25 basis point (a basis point is one hundredth of one percent) hike, Fed officials believe that “ongoing” rate hikes will be necessary to accomplish their goal. This forecast was confirmed on Friday when the core personal consumption expenditures (PCE) price index, the Fed’s preferred measure of inflation, increased more than expected in January and was up 4.7% from a year ago. The increase was also more than in December, which was revised higher. This unfavorable piece of data raised the possibility of a 50-basis point rate hike in March and sent bond yields higher. (Bond prices and yields move in opposite directions).  The 2-year Treasury yield ended the week at 4.8% while the 10-year Treasury yield rose to 3.95%, putting pressure on stocks. With additional rate hikes in the forecast, the peak or terminal federal funds rate has now been raised to between 5.25% and 5.5% with the prospect that the Fed may keep rates higher for longer to bring down stubbornly high inflation. Earnings results from two prominent retailers also raised some concerns. Although Walmart and Home Depot beat quarterly earnings estimates, they both offered weak guidance going forward. With so much uncertainty with regard to inflation, the economy and the Fed’s monetary policy, the stock market is likely to remain choppy over the next several months.

Last Week

Gross domestic product (GDP) for the fourth quarter was revised lower to 2.7% growth from 2.9% as consumer spending wasn’t as strong as initially expected. Existing home sales fell in January to the lowest level in 12 years and have now declined for 12 straight months while new home sales rose to a 10-month high as prices declined. However, higher mortgage rates could slow these sales going forward. Weekly jobless claims edged lower to 192,000, 3,000 less than in the previous week and below the estimate of 197,000. The University of Michigan consumer sentiment index in February increased from the January reading and was better than forecast.

For the week, the Dow Jones Industrial Average fell 3.0% to close at 32,816 while the S&P 500 Index dropped 2.7% to close at 3,970. The Nasdaq Composite Index lost 3.3% to close at 11,394.

This Week

Durable goods orders for January are expected to decline after increasing in December and the consumer confidence index for February is forecast to be slightly higher as the labor market continues to be strong. The ISM Manufacturing Purchasing Managers’ Index (PMI) for February is expected to match the reading in January and be below the expansionary level of 50 while the ISM Services PMI is expected to approximate the level in January and be solidly in expansion territory.

Among the most notable companies scheduled to report quarterly earnings this week are Occidental Petroleum, AutoZone, Rivian Automotive, Zoom Video Communications, Agilent Technologies, Workday, HP Inc., Hewlett Packard Enterprise, Dell Technologies, Salesforce, Broadcom, Nordstrom, Target, Lowe’s, Dollar Tree, Best Buy, Costco Wholesale, Kohl’s, Macy’s, Anheuser-Busch InBev, Hormel Foods and Kroger.

Portfolio Strategy

The biggest headwind for the stock market now appears to be higher interest rates and bond yields as the economy remains fairly strong and inflation is not declining fast enough to reach the Federal Reserve’s target of 2%. The consensus had been that the economy would fall into a recession this year with a soft landing also a distinct possibility if the Fed was able to thread the needle. The fear now is that the economy might be headed for a “no landing” in which the Fed must raise interest rates more than expected to slow the economy and reduce inflation. The labor market has defied expectations and remains strong as evidenced by the January employment report that saw 517,000 new jobs created, nearly triple Wall Street estimates. Weekly jobless claims have also remained surprisingly low since the beginning of the year. The prospect that the Federal Reserve will be forced to raise interest rates even further has caused the bond market to sell off, resulting in lower bond prices and higher bond yields. The Bloomberg U.S. Aggregate Bond Index had gained over 3% at the end of January but has fallen this month and is up less than 1% now for the year. With so much uncertainty with regard to the direction of inflation and the Feds’ plans to combat it, investors would be wise to shorten their fixed income portfolios and take advantage of the higher yields available on short-term Treasury bills and notes as well as in ultra-short bond ETFs and short duration bond mutual funds. After starting the year at 4.43%, the 2-year Treasury yield has risen to 4.8%. Although the “real” yield adjusted for inflation on this note is not that high, an investor is guaranteed to receive his principal back at maturity provided the U.S. government doesn’t default. Ultra-short term bond ETFs with average maturities less than one year are diversified among government bonds, high quality corporate bonds, mortgage-backed securities and asset-backed securities and offer yields of 4.5% or more and are very liquid. Because of their short duration, their principal values are also very stable and not prone to significant declines like intermediate and longer-term bond funds are.