Investment Update

Weekly Investment Update (02/03/2023)

This Week’s Highlights
  • The Fed: The Fed decelerated the pace of interest-rate hikes to 25 basis points and continues to reiterate a data-dependent approach to determine the interest- rate peak for this hiking cycle.
  • Employment: Nonfarm payrolls increased far above consensus estimates, a strong report despite distortion from seasonal factors. Other labor market indicators this week suggest the labor market remains tight.
  • Europe: Near-term tailwinds of lower energy prices, fiscal stimulus, and China’s reopening alongside an incrementally more dovish ECB supported broad risk sentiment this week.

The Fed Continues a Deceleration in Rate Hikes

On Wednesday, the Federal Open Market Committee (FOMC) unanimously voted to raise its policy rate by 25 basis points, as was widely anticipated, marking the second deceleration in the pace of rate hikes. Contrary to the December meeting, the February meeting brought a more hawkish FOMC statement and a more balanced press conference. The FOMC retained its commitment to “ongoing increases” and signaled that it is premature to discuss pausing. However, one key change made to the February statement was the acknowledgement of the recent ease in inflation, though its still-elevated levels were noted as well. We continue to monitor the three key categories of inflation for the Fed: core services excluding shelter, core goods, and shelter. Although Fed Chair Powell pointed to disinflation in the goods sector, the focus remains on core services ex-shelter, which accounts for 56% of core inflation and has yet to see disinflation. A majority of the core services ex-shelter inflation category is sensitive to wages, and therefore upward pressure is unlikely to subside without further slack in the labor market.

The statement also contained a pivotal replacement of the verbiage around determining the “pace” of future rate increases with the “extent” of future increases, signaling a potential nearing of peak interest rates. By slowing the pace of hikes, the Fed is enabling additional data to better influence the ultimate peak of rates. Current market pricing deviates from the scenario that the Fed has outlined; while projections from the Fed call for 5.1%, the market is pricing year-end interest rates of 4.6%. The market is optimistic that inflation will subside faster than the Fed’s own expectations.

Equity markets reacted positively to this meeting, buoyed by Powell’s dovish comments, particularly that the disinflation process has begun, along with his minimal concern regarding the recent easing of broad financial conditions. The VIX, which measures volatility in the stock market, hit a one-year low, and interest-rate volatility in the Treasury market continued its downtrend. With a slowing the pace of interest-rate hikes, we expect to see decreased interest-rate volatility and an ongoing data-dependent approach by the Fed. As Powell highlighted the importance of incoming data over the next few months as a significant influence on their outlook, we expect the Fed to remain attuned to the two-sided risks of monetary policy tightening.

Perhaps further insight will be divulged by Powell next week during an interview at The Economic Club in Washington D.C.

Nonfarm Payrolls Above Expectations, Although Seasonal Factors Are at Play

Nonfarm payrolls increased by 517,000 in January, far above the consensus estimate of 188,000, with net upward revisions of 71,000 over the prior two months. Job growth was widespread, led by gains in leisure and hospitality, professional and business services, and healthcare. Meanwhile, the unemployment rate hit a 53-year low, the lowest since 1969, as it fell to 3.4% from 3.5% despite a slight increase in labor force participation. Although job growth strengthened, year-over-year average hourly earnings continued decelerating from 4.8% to 4.4%.

In addition to payrolls and unemployment, other labor market indicators this week further reinforced the notion that a tight labor market remains. The number of job openings rose to 11.0 million in December from 10.5 million in November, and initial jobless claims averaged 192,000 in January, the lowest average for a month since April 2022. Despite a rise in layoff announcements in recent weeks, claims data suggest that laid-off employees may be getting re-hired quickly, especially with so many job openings.

It is important to note that both nonfarm payrolls and unemployment claims are exposed to large seasonal factors this time of year; there is also a population adjustment to the Household Survey, which reported a strong reading at 894,000. The Fed will have the February labor report to evaluate before its March meeting as it looks to slow employment growth in order to reduce wage pressures. While incoming data will influence the direction of Fed policy, this Friday’s strong jobs report makes it difficult for the Fed to move much more dovishly in the near term, keeps two additional rate hikes on the table, and makes interest-rate cuts this year a bit less probable.

European Markets Rally on the Back of Unseasonably Warm Weather, Signs of Declining Inflation, and an Incrementally More Dovish Central Bank

Unseasonably warm weather combined with better-than-expected sourcing of non-Russian natural gas has taken the worst-case scenario off the table for Europe this winter. With Northwestern Europe experiencing the third warmest winter on record, natural gas prices have fallen 50% since summer highs, and concerns over serious gas rationing have been alleviated as European Union gas storage has shifted from the low end to the high end of the historical range. Recent economic data have surpassed investors' expectations after some grim December data. The eurozone composite PMI rebounded in January, returning to expansionary territory of 50.2 as services moved to 50.7 despite manufacturing remaining in contraction. Resilient household income, boosted by social benefits, buttressed European households during the recent energy crisis. Declining inflation should help consumption by lifting real wages, in turn boosting consumer confidence and causing savings intentions to fall.

Importantly, European inflation appears to have moved past its peak on the back of falling energy prices even though it remains notably above the European Central Bank’s (ECB) target of 2%. The annual rate of inflation in the eurozone has fallen for three months in a row with consumer prices rising 8.5% in January relative to the year prior, which is notably lower than the 9.2% year-over-year increase seen in December. However, core inflation of 5.2% remained constant in January relative to December, raising some concerns regarding how persistent core inflation could be. With still-high inflation, the ECB hiked its target rate an additional 50 basis points to 2.5% this week and signaled it is likely to enact another 50 basis points increase in March as it vowed to “stay the course in raising interest rates significantly at a steady pace.” Of the major central banks, the ECB remains on the more hawkish end of the spectrum. We expect the ECB to lag but still follow in the Fed’s footsteps in becoming increasingly dovish upon signs of easing inflationary pressure. ECB guidance becomes much vaguer after March as it will then “evaluate the subsequent path of its monetary policy,” signaling it may be open to slowing the pace of tightening or perhaps even consider a pause in May. Market pricing confirms investor expectations that the Fed is closer to its peak rate than the ECB, and the market is also pricing in cuts for the Fed, but not yet for the ECB.

The near-term tailwinds of lower energy prices, fiscal stimulus, and China’s reopening, combined with the ECB’s acknowledging the prospect of dialing back its aggressive inflation fight, supported broad risk sentiment this week. Still, we must keep in mind the powerful and lagged impact of the ECB’s prior hikes, the full extent of which will still not be felt for some months. Bessemer portfolios modestly increased their exposure to Europe as the region moved from 7% to 8% of an all-equity portfolio, still below the benchmark weight of 14%.

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