Stocks gained 7% in the first quarter of 2023, snapping a painful three-quarter losing streak and overcoming a sudden new and unexpected threat to the banking system that has complicated the Federal Reserve’s aggressive yearlong monetary tightening campaign to stop inflation without triggering a recession.
The confluence of a banking crisis and nine hikes in interest rates by the Federal Reserve in the past year has rattled Wall Street at a time when the yield curve is signaling a recession is likely to begin in 2023, and the index of leading economic indicators (LEI) has declined for 11 straight months, also signaling a recession in 2023
The returns on the Standard & Poor’s 500 Index for the past 33 quarters ended March 31, 2023 — eight years and three months — are shown in this table. What stands out is that the first three quarters of 2022 were pretty lousy. What’s less obvious is that volatility has increased in recent years.
The S&P 500 Index, which holds the 500 largest publicly investable companies in the United States, is not comprised of equal positions in the 500 companies. Rather, the index is market-weighted, which means that companies like Apple, Meta and Microsoft dominate the performance of the index, and they soared in the first quarter of 2023.
The average annual return on the index in modern history, starting in the 1950s, is about 10% annually. So, the 7% return in the fourth quarter represents an outsized quarterly return.
The main story of these 33 quarter is that stocks have only occasionally shown a quarterly return around 2.5%. Volatility increased in recent years, and stock investing since the pandemic has been an emotional roller coaster.
Turning to the economic fundamentals driving stock market returns, good news about inflation was released Friday morning. The unnecessarily long-named Personal Consumption Expenditure Deflator (PCED) Index slowed more than expected. In the 12 months through February 2023, the price of the PCED index indicated prices declined by 5%, better than the expected rate of 4.7%.
The big question is how long it will take to decline back to the 2% annual rate targeted by the Federal Open Market Committee. The gray dotted lines in the chart show how the inflation rate had hugged the 1.5% annual rate for over a decade before the pandemic and how Russia's invasion of Ukraine sent prices skyrocketing in 2021, triggering the worst inflation in over four decades.
Federal Reserve policymakers are predicting inflation will continue to drop. The gray dotted lines show the high- and low-range of forecasts made by central bankers at their last meeting on March 22. They expect the PCED inflation index to fall to between 2.2% to 2.8% by the end of 2023.
The Fed’s inflation forecast has been wrong many times in recent years because of unexpected problems, like the pandemic-related supply chain problems, the Russian war in Ukraine, and runs on small- and medium-sized banks. However, if there are no additional problems like those, or if known problems are resolved, the Fed’s forecast might be correct.
The personal savings rate ticked up in February, according to data released Friday, but it remained lower than before the pandemic. Stimulus checks, unemployment bonuses, and assistance to businesses after the outbreak of Covid-19, swelled cash held by consumers in checking and savings, according to the M2 measure of money supply, and it is being spent down now and fueling consumer strength amid heightened uncertainty.
Despite the 5% rise in prices, as measured by the PCED index, disposable personal income after inflation soared 3.4%. With Americans netting a 3.4% increase in disposable income after accounting for inflation, personal spending increased by 8.3%, or 3.3% after inflation.
Consumers account for 70% of U.S. economic growth. Their spending strength, despite the 12-month inflation rate of 5% and banking instability, is a positive sign.
Economic indicators are unusually dichotomous. The index of U.S. Leading Economic Indicators is signaling a recession will occur by the end of the year, and the yield curve – the difference between the yield on a 10-year U.S. Treasury bond and the yield on a 90-day Treasury bill – has been negative for many months. These two signals have reliably been followed by recessions in modern U.S. history.
The S&P 500 stock index closed Friday at 4109.31, gaining +1.44% from Thursday and +3.48% from a week ago. The index is up +83.66 from the March 23, 2020, bear market low and -14.33 below its all-time high of January 3, 2022.
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