After rebounding sharply to start the year, stocks are experiencing some volatility as better-than-expected economic readings, but evidence of sticky inflation, raise concerns that the Federal Reserve will raise interest rates higher for longer.

Meanwhile, fourth-quarter earnings season saw earnings fall by 1% year/year with downward revisions to the 2023 outlook now calling for just 1% earnings growth.

Inflation falling slower than expected, coupled with further short-term interest rate increases and lackluster earnings, are likely to be headwinds for stocks and other risk assets.

Better-Than-Expected Business Surveys and Retail Sales

The S&P Global Flash U.S. Composite PMI (a first look at February private sector business activity) climbed in February to its best level and in expansion territory for the first time since June 2022. Services sector optimism about the year-ahead outlook increased for the second consecutive month, reaching its best level since last May. Manufacturing optimism about the economic outlook in the next 12 months was little changed from the prior month and robust overall.

In both services and manufacturing, cost burdens eased but selling prices picked up. This suggests that firms continue to have pricing power, which bodes well for their profitability, but also implies that consumer price inflation may be stickier than anticipated.

The strength of the U.S. consumer was evident in January’s retail sales release. Retail sales surged 3.0%, more than erasing the declines in the prior two months. It was the biggest increase since March 2021, and well above the consensus of 1.9%. Excluding the pandemic recovery, this was the biggest jump in sales since October 2001.

Virtually all retail categories posted gains, and the majority increased by more than their average gain since 1992. Vehicle sales jumped 5.9%, the most since March 2021, as both unit sales and prices increased. A few other standouts included: restaurant and bar sales (+7.2%), furniture (+4.4%), electronics (+3.5%, first increase since April 2022), and general merchandise (+3.2%, first increase in four months). Consumer demand is being supported by continued labor market strength and wage gains, continued utilization of credit, and savings accumulated during the pandemic.

The improvement in business surveys and retail sales comes on the back of some better-than-expected economic data for January, including nonfarm payrolls and CEO and consumer confidence surveys. The combined evidence suggests that the odds of a soft landing for the economy have improved, despite some leading indicators pointing in the direction of recession.

Inflation Remaining Stubbornly High

The Consumer Price Index (CPI) increased 0.5% in January, the most since last June, and above the consensus of 0.4%. Core CPI, which excludes energy and food, increased 0.4%, the most in four months, and above the consensus of 0.3%. On a y/y basis, the CPI ticked down to 6.4% from 6.5% in the prior month, the slowest pace since October 2021, but above the consensus of 6.2%. Core CPI eased to 5.6% from 5.7%, and above the consensus of 5.5%. Although off their peaks last year, both measures are much higher than pre-pandemic.

This stubbornly high inflation, coupled with the better-than-expected economic readings cited above, suggests that the Fed will have to keep monetary policy tighter for longer.

Results from Earnings Season

With most of the fourth quarter (4Q) 2022 earnings season behind us, companies have generally managed to meet weak earnings expectations. Between the beginning of 4Q 2022 and the start of earnings season in January, expectations dropped by 7%. By the time reporting season began, S&P 500 earnings were expected to contract by 1% year/year. Earnings did fall by 1% despite strong Energy EPS growth of 57%. Excluding Energy, index-level earnings declined by 5%, also in line with expectations.

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