Market rally interrupted as spotlight shifts to recession worries

Equity markets moved lower on Thursday amid growing recession concerns. Wednesday's Federal Reserve announcement stoked worries over a potential "higher-for-longer" interest-rate outlook, while a weak retail-sales report released Thursday morning added to the market's sour mood, highlighting headwinds the economy faces in the wake of this year's aggressive Fed-policy actions to fight inflation. 

• Stocks pull back as spotlight shifts from inflation to growth – This week's one-two punch of Fed interest-rate commentary and a tepid retail-sales report has shifted the focus toward the health of the economy. Retail sales declined 0.6% in November compared with the month prior, a notable slowdown that signals consumer spending may finally be showing some wear and tear from higher interest rates¹. This follows strong retail spending growth in October, so November's drop may be somewhat overstated in the broader scheme. A look under the hood shows a sharp drop in auto sales last month and an even steeper decline in building-material sales. Neither comes as a surprise to us, as higher financing costs pose the largest headwind to big-ticket purchases. The silver lining here is that automobile and shelter (housing prices, rents) costs have exerted significant upward pressure on inflation this year, so the slowdown in sales in these areas offers additional evidence that inflation will continue on its path of moderation. Overall, this is consistent with our view that the lagged effects of restrictive Fed policy will prompt an economic slowdown in 2023. Importantly, however, the labor market remains quite healthy, which we believe will soften the blow for consumers and produce a more mild slowdown instead of a more severe downturn.
• Fed policy still in the driver's seat heading into 2023 – All eyes will remain squarely focused on Fed policy in the months ahead, as the central bank attempts to quell inflation without inflicting too much damage to the health of the economy. We think we're approaching a point at which the Fed can consider pausing rate hikes, with our expectation that the Fed may raise rates by another 50 basis points (0.50%) or so early in 2023. We suspect the market's focus will then shift to 1) how long the Fed will keep rates steady and 2) the impact interest rates and financial conditions will have on economic growth in the coming year. This will, in our view, instigate bouts of market volatility as the pendulum swings between the pessimism of the Fed potentially overtightening and the optimism of a new phase in which the Fed is no longer raising rates.
• Markets have rebounded – Thursday's pullback is a reminder of the challenging year markets have endured in 2022. It shouldn't be lost, however, that stocks and bonds have rallied smartly in recent weeks, so this week's dip should be viewed in a wider context.  The S&P 500 is up 11% since mid-October, recouping a portion of the year's decline¹. Meanwhile, with rising rates penalizing bond returns in 2022, the 0.75% decline in 10-year interest rates in the last two months has brought a welcome rebound for bonds of late as well. We think investors can expect more market swings as we turn the corner into the new year. However, we also expect better stock and bond returns to take shape in 2023, supporting the case for opportunistic year-end rebalancing and dollar-cost-averaging² strategies to take advantage of this volatility and best position portfolios in alignment with your longer-term goals.

Craig Fehr, CFA
Investment Strategist

^{1 Source: Bloomberg}

^{2 Dollar-cost-averaging does not guarantee a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.}