Market Perspective: Searching for Spring

The big question, of course, is whether the Federal Reserve and other central banks will find a way to subdue inflation without causing a recession. As with the weather, though, the signs are frustratingly muddled. Corporate earnings, for example, have weakened, while other evidence suggests global manufacturing activity is actually strengthening. At the same time, longer-term Treasury yields have risen as the Fed has signaled it's not done raising interest rates just yet.

The absence of clarity can be unsettling. Here's how we see things shaping up.

The Fed's messaging combined with stronger-than-expected labor market data have renewed concerns that a bond bear market, with falling prices and rising yields, may be coming. We don't think that's likely. Here's why:

1. The Fed has allowed the yield curve to remain inverted, with longer-term yields below short-term yields. In past cycles, intermediate- and long-term bond yields have tended to stay low or keep falling until the Fed is near the end of its rate-hiking cycle—and bottom out at the onset of recession. Each recession is different, but the historical pattern has been consistent.

Where does that leave us now? Estimates of the terminal rate for interest rates are rising, while the Fed's rate hikes continue to push the yield curve to more steeply inverted levels. As a result, an inverted yield curve is likely to be a key feature of the Treasury market in 2023.

2. Inflation has been declining, and inflation expectations are moderate. The Fed has recently indicated concern that inflation in the service sector (excluding housing) is stubbornly high. However, weakening consumer spending suggests price growth will continue to slow.

Global manufacturing has lagged in the post-pandemic era as inventory shortages turned to gluts last year, even as global demand for services (like travel and entertainment) boomed. In fact, according to purchasing managers' index (PMI) surveys of manufacturing business leaders, global exports of manufactured goods, and revenues of manufacturing firms, factory output actually fell into a recession at the end of last summer.

Now, however, signs have started to emerge that manufacturing may be bouncing back as surplus inventories are drawn down. Indeed, activity in leading industrial-driven economies like China and Germany is picking up, with the China PMI and German Ifo Business Climate Index both having recovered from lows reached in September-October 2022. Globally, manufacturing output is still weak, but forward-looking expectations and components such as new-orders-to-inventory ratios may be signaling the start of a rebound.

The tradeoff, of course, is that such a recovery could prevent central banks from the enacting the interest rate cuts that the market seems to expect later this year. After forecasting further hikes for the first half of this year (see the orange columns in the chart below), the futures market has priced in rate cuts beginning in the second half of the year (blue columns) for many of the major central banks.

If economic green shoots do take root, stocks that tend to benefit from rate cuts, such as growth stocks, could suffer, while cyclical value stocks may fare better.

Kevin Gordon, Senior Investment Strategist, contributed to this report.