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March 2023 / VIDEO

Recession Avoided?

Positive economic news in the near term could mean a more hawkish Fed, which would be a headwind for the economy and equity markets

Key Insights

  • Equity markets started the year on a positive note, boosted by economic surprises in the U.S. and improved outlooks in China and Europe.
  • In our view, favorable economic news in the near term could mean a more hawkish Federal Reserve, which would be a headwind for the economy and equity markets.

Video Transcript

The U.S. stock market rallied sharply in January and into early February, with the S&P 500 Index registering a year-to-date total return of 9% through February 2. The rally was driven by a series of encouraging reports about the health of the U.S. economy, alongside positive developments abroad—including the reopening of the Chinese economy and falling energy prices in Europe.

The two most notable positives for the U.S. came from:

  1. Employment: where new jobs reported rose to 517,000 in January after marching steadily lower over the previous five months.
  2. Consumer spending: where credit card spending increased sharply after dipping to concerning levels in the latter part of 2022.

These positive developments, combined with the ongoing decrease in inflation, meant that many investors began to believe that both a U.S. and global recession could be avoided.

Rates Higher for Longer 

Unfortunately, a more somber outlook took hold in the middle of February as investors began to recognize that these positive developments were likely to lead to a more hawkish Fed—as evidenced by the 10-year U.S. Treasury yield rising from 3.39% on February 2 to 3.96% by February 21. 

This happened because futures markets shifted their predictions for the path of the federal funds rate notably higher. In the beginning of February, futures markets projected the fed funds rate to peak at 4.89%. But by February 21, that projection had shifted to a peak of 5.37%. More notably, the futures market also raised its expectation for rates over the long run from 2.87% to 3.63%.

Because Inflation is Not Falling Fast Enough 

So why would the market expect the Fed to be more hawkish, given that the recent CPI report confirmed that inflation is falling? It’s because the portion of inflation that the Fed is most worried about falls into the category of “services excluding shelter.” And, unfortunately, this portion of inflation has not yet shown signs of falling—and it also happens to be the portion of inflation that is most sensitive to wages. 

The Fed recognizes that, while strong employment and consumer data are a signal that the U.S. economy is on healthy footing, they are also a signal that wage inflation is likely to remain stubbornly high. This means that the Fed probably needs to tighten policy even further in order to get wage inflation under control.

The bottom line is that the Fed is stuck between a rock and a hard place. They want the economy to avoid recession, but they also know that they need to weaken the labor market in order to get inflation under control.

Conclusion 

In conclusion, while there certainly are reasons to be optimistic about the near-term path of the U.S. economy, these encouraging signs may be short-lived because they could force the Fed into a more hawkish stance.

As a result, we remain cautious about the medium-term path for the U.S. economy. At least for now, any positive economic news could ultimately just mean a recession is delayed rather than avoided. So, despite a somewhat rosy near-term outlook, T. Rowe Price’s Asset Allocation Committee is maintaining an underweight position in stocks relative to bonds.

IMPORTANT INFORMATION

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.  

It is not intended for distribution to retail investors in any jurisdiction.

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March 2023 / VIDEO

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