CIO Note: Orchestrating optimism

In short

  • Perception of a shift in the Fed’s narrative to a slightly more dovish tilt buoyed investors following the Fed’s first meeting of the year. 

  • Gold may be shining a bit brighter to start the year, but without a weaker U.S. dollar, the luster may come off sooner than expected. 

  • Technology names benefited from a January bounceback, but with earnings on the decline, the rally could prove short-lived. 

The Fed's positive tone piques investor interest

One of the constants over the last two years has been the importance of Fed meetings in shaping investor sentiment. While the Fed’s views and actions in 2020 were clearly responsible, at least in part for the U.S. economic recovery, the inflation experienced has also been attributed to these actions. It has therefore been critical, at least in the eyes of the Fed, to remain hawkish in both actions AND narrative. 

However, markets, particularly the bond markets, have questioned whether the Fed actually needs to meet and/or exceed the fed funds targets outlined in last December’s dot plot. Perhaps instead there might be some changes as inflation trends lower, and those who were looking for a pause and/or a pivot were likely thrilled with the results of February’s Fed meeting. 

While the Fed still raised rates by 0.25% to a fed funds range of 4.5% to 4.75%, it was the language change in the Fed’s statement and the comments from Chair Jerome Powell during the press conference following the decision that created the most excitement for investors. 

The admission by Powell that he found the improvement in inflation without a meaningful increase in unemployment “gratifying” along with his pronouncement that that Fed has been pleased to see the “transitory” inflation in goods subside as expected appear to point to a greater level of optimism regarding the potential for a soft landing. In addition, when asked about the recent loosening of financial conditions as a possible counteraction of the Fed’s attempts to tighten, Powell noted that the Federal Open Market Committee is monitoring financial conditions, but he did not believe they had loosened meaningfully since December. 

Finally, the statement itself reflects the removal of several key risks for prices, namely public health and the war in Ukraine, which indicates that the Fed believes that shorter term imbalances resulting from the invasion of Ukraine and the pandemic are unlikely to upset the improving trend in inflation. 

While the markets focused on the narrative outlined above, there were several comments made by Chair Powell that were more cautious in nature. Powell stated that he believed it would be a major mistake for the Fed to become more accommodative before inflation is truly anchored, and that he believes that not going far enough is a greater risk than potentially going too far and being required to walk back restrictive measures. 

In addition, while he acknowledged the improvement in consumer and producer prices, he stated that given the unique set up for the current economic environment, it was unclear whether the improvement in inflation would continue at the same pace or slow based, in our interpretation, on the stickiness of wages.  

Indeed, it was the strength of the January non-farm payrolls report which knocked some of the wind out of the post-Fed rally, as the U.S. economy added +517k versus expectations of only +185k jobs. In addition, the unemployment rate fell from 3.5% in December to 3.4% in January and wages were up +4.4% year-over-year. 

While Fed Chair Jerome Powell cited the continued resilience in the labor market as a sign of optimism, a tight labor market is likely to keep the Fed tethered to restrictive policy as wage growth is unlikely to be pressured lower without a meaningful increase in the number of workers seeking employment. The current pace and type of hiring appears to reflect the ongoing shift from goods to services spending; however, with savings rates down to pre-pandemic levels, a deceleration in consumer activity may represent the most obvious catalyst for slower job growth into the back half of 2023. 

Overall, our view is that the Fed is acknowledging the slowing economic activity and decline in inflation that could create an opportunity for a pause or even a pivot if we are looking to 2024. Powell re-affirmed that the Fed is not projecting a rate cut this year; however, he noted that a new dot plot and economic projections released in March would reflect any additional economic deterioration and/or price stability. 

We also believe that while the bond market is clearing anticipating lower rates, this is based on the assumption that economic activity will slow meaningfully, potentially to recessionary levels. The next 2-3 months will be critical in determining if the Fed can get to a place where it can pause and allow the rapid hiking cycle to fully transmit to the economy, and in the interim, we believe the oscillation between risk on and risk off trading activity will continue, especially as earnings are pressured lower. 

Our view is that exposure to stocks as well as bonds is warranted during such a period, with a continued emphasis on short duration, high quality fixed income and a diversified basket of global equities made more attractive as the U.S. dollar weakens. We will look for opportunities to rebalance and reallocate as appropriate should rate expectations fall even more quickly, and should spreads widen, opportunities to increase credit exposure will also be in focus for us.

Beware of all that glitters

Gold is once more an area of interest for investors, and as such, it’s worth revisiting our views on the asset. Long considered by many investors a safe haven for those seeking shelter in the proverbial storm, gold is perhaps one of the most glaring exceptions to the rule that perception becomes reality. The perception that gold is a strong store of value goes back to the Bretton Woods agreement when the U.S. dollar’s value was tied to a defined quantity of gold. The gold standard, as it was called (and still used colloquially today), was abandoned in 1971 by the United States, but the shine of gold as an asset persisted. 

This persistence is most evident when describing gold as an inflation hedge. Investors often cite as fact that the price of gold is positively correlated with inflation, implying that gold will appreciate in periods of high inflation. In fact, the two aren’t actually correlated at all. If one makes a long-term comparison of gold and CPI, averaging the correlation over time yields something that looks non-correlated, rather than positively correlated. Perhaps the most important thing to consider is the period when gold and inflation were most closely correlated – this was during the hyperinflationary energy shock of the 1970s. Investors responded to the weak dollar, high energy prices and political uncertainty in the 70s by purchasing gold.  

In 2022, therefore it was hardly surprising to see proponents of gold investing calling for another strong performance from the precious metal. Instead, a different set of circumstances arose – namely, stabilizing energy costs despite higher overall inflation, a stronger dollar and a political backdrop which produced a midterm election with surprisingly better results for the incumbent party than anticipated. As such, gold - as measured by a common ETF proxy as an equivalent for gold prices, GLD – actually declined by -0.77% even as inflation shot higher.  

However, gold is performing better in 2023. A big part of this outperformance is due to the U.S. dollar weakening, but there are also geopolitical concerns and a desire to diversify into real assets that might be providing some of the momentum. While there might be a near term opportunity in the metal, caution is likely warranted if flocking to gold as a more conservative store of value. 

In fact, as outlined in our previous insights, gold as measured by gold spot prices is more volatile over time and offers lower returns than U.S. stocks over the last 30 years – hardly a winning combination. In short, while gold may produce positive returns over shorter term time periods, inclusion of the metal as anything more significant than a small portion of a real assets allocation gives us pause – especially if the U.S. dollar stabilizes. 

Source: YCharts as of 2/10/2023

Examining tech stocks' recent renaissance

A final point as to the impact of the Fed’s hiking cycle nearing its inevitable conclusion is the rebound in technology stocks to start 2023. The performance of technology stocks in late 2021 and 2022 reflected the impact of higher rates on long duration names, and therefore it is not surprising to see positive momentum for these stocks at this point in the cycle. Volatility as measured by the VIX has declined as well, reflecting the greater level of certainty in terms of the Fed’s actions. However, anchoring to a set of conditions that existed before the pandemic and anticipating that companies which performed well in the years leading up to 2020 is not likely to yield the desired outcomes.  

Rather, investors should acknowledge that in an environment where earnings are being pressured by higher costs and higher rates, both of which could persist longer than anticipated, a combination of management effectiveness, balance sheet and cost discipline and the ability to grow top line revenues in the absence of a secular tailwind should be the combination of attributes to target. 

While many large and mega cap technology companies exhibit these attributes, investors in 2023 appear somewhat indiscriminate in their determination, and as such, are likely setting the stage for another modest move down for some of these companies, particularly if those organizations fail to generate profits. As such, our view is that the most recent rally in long-duration growth names could fizzle, but that over the longer term, there are still promising opportunities for investment in the sector. 

Source: YCharts as of 2/10/2023

The written financial and economic data are obtained from FactSet, the Federal Reserve, the U.S. Bureau of Economic Analysis, the U.S. Bureau of Labor Statistics, Bloomberg and YCharts as sources but not limited to such. The accuracy and completeness of the financial or economic data are believed to be reliable, but has not been independently verified. 

Please feel free to reach out to your SVB Private Wealth Advisor for a deeper discussion regarding the points above, or a review of your current plan to ensure it remains aligned with your long-term needs and goals. 

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