Amada Agati:  

In this edition of Adding Alpha and despite my love of all things vinyl, I really feel like a broken record. So let's take stock of where markets are two months into the new year and gauge what likely comes next. As goes the Fed so goes markets. Markets have been fighting the Fed ever since the CPI report back in November of 2022 came in well below consensus expectations.

That's really what catalyzed the very low-quality rally we've seen leading the market higher ever since. We've gone from a pretty delusional market rally to a reality check in fairly short order.

Technical indicators have started breaking down. Market leadership is rotating and evolving, bond yields are rising, and rate hike expectations are shifting higher.

The S&P 500 recently broke through its 50-day moving average and it's currently trading sideways right along that line. Market breadth is also faltering with fewer individual stocks making new highs, and many more making new short-term lows as earning season results have been fairly disappointing.

Since the most recent Fed announcement on February 1st, even some key economic data points have started to confirm what we've been concerned about right along. And the reality is finally setting in - that the Fed just isn't close to being done with its tightening of monetary policy.

So I'm sticking with my phrase "longer for longer" to describe what's going on here - more rate hikes, a higher overall terminal rate, and a longer overall tightening cycle.

While the first 300 basis points of decline and inflation from the peak seemed, quote, unquote, "easy," the next 300 basis points will be harder to come by because inflation drivers outside of food and energy costs tend to be pretty sticky.

The labor market, China's reopening, even Russia and Ukraine. These are just a few of the sticky drivers keeping inflation elevated.

As investors, we've been conditioned to high volatility and warp speed over the course of the cycle, but it's just going to take a lot longer than any of us want for the Fed to actually get out of the driver's seat. Investors beware.

The Fed funds futures market is now priced for a 25 basis point rate hike in March, with Fed governors leaving the door open to do as much as 50 basis points. Followed by another 25 basis points in May and possibly another 25 basis points in June.

That's quite a turnaround from last fall when investors were hoping the Fed would already be taking a pause at the upcoming March meeting.

It also means the Fed's terminal rate is moving higher. It's now up to 5.4% compared to the Fed's current dot plot of 5.1% based on market expectations. 

And so, of course, this is indicating more rate hikes ahead. The most important determinant for the market's path forward is to understand the final destination for monetary policy.

And, as a result, this is probably our biggest concern in gauging the timing and severity of the forthcoming recession. Interest rates are just going to be very restricted for markets, the economy, and financial conditions.

Don't forget, the monetary policy also acts with a lag, so the economy is just now starting to feel the effects of some of the previous rate hikes.

And the Fed is still in the driver's seat; they're still going. For now, we're still expecting a mild recession; AKA, a softer landing scenario to occur this year.

And that equates to about a 1 to 2% GDP decline year over year, and about a peak-to-trough decline in earnings of about 10%. But our economics team has recently pushed back the start date of the recession by about a quarter into Q3.

Continue to run a defensive playbook in portfolios but stay invested. In this macro and Fed-dominated environment, investors just aren't getting paid to take big bets. You have to stay well diversified.

While I would love to talk endlessly about all of the fundamental drivers of the markets in the economy, I really do feel like a broken record, as there still are really only two critical variables for the path forward.

How fast inflation can fall towards the Fed's 2% target --not very fast --and what the Fed is ultimately doing about it. They're going to keep chipping away at it.