The year 2023 appears to be a wobbly year for the stock market. The next step for investors is their fight against inflation.

The stock market ended February on a shaky note, intensifying concerns about the sustainability of an early 2023 rise.

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Stronger-than-expected economic statistics and higher-than-expected inflation readings have prompted investors to reconsider how high the Federal Reserve will raise interest rates.

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"The thought that stock markets would see a huge upward surge when the Fed was still rising and the market was underestimating what the Fed was going to do," said Lauren Goodwin, economist, and portfolio strategist at New York Life Investments.

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Market participants have come around to the Fed's viewpoint. Fed funds futures at the end of January showed predictions that the Fed's benchmark interest rate would fall below 5%, despite the central bank's projection for a peak in the 5% to 5.25% range. Furthermore, the market expected the Fed to deliver more than one rate decrease before the end of the year.

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The perception began to turn with the release of a January jobs report on Feb. 3 that showed the US economy generated a much larger-than-expected 517,000 jobs and the jobless rate fell to 3.4%, the lowest since 1969. Add in higher-than-expected January consumer and producer price index readings, as well as Friday's increase in the core personal consumption expenditures price index, the Fed's preferred inflation gauge, and the market's perspective on rates changes dramatically.

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Participants now expect the Fed to raise interest rates over 5% and keep them there until at least the end of the year. The issue now is whether the Fed will raise its estimate of where rates will peak at its next policy meeting in March.

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This has resulted in a drop in Treasury rates and a fall in stock prices, with the S&;P 500 down approximately 5% from its 2023 high set on Feb. 2, but still up 3.4% year far through Friday.

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Investors aren't only learning to live with the Fed's rate expectations; they're also aware that getting inflation down will be a "bumpy" process, according to Michael Arone, chief investment strategist for the SPDR business at State Street Global Advisors, in a phone interview. After all, it took former Fed Chairman Paul Volcker two recessions in the early 1980s to eventually end a period of runaway inflation, he pointed out.

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The surge to the S&P 500's was driven by what some experts mocked as a "rush for garbage," with last year's greatest losers, such as highly speculative shares of firms with no earnings, among the leaders on the way back up. These equities suffered notably last year as the Fed's aggressive rate rise cadence drove up Treasury rates considerably. Rising bond rates make it more difficult to justify investing in stocks whose values are dependent on profits and cash flow projections for the foreseeable future.

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This month's inflation measurements have all been higher than projected, resulting in a "reversal of everything that was working earlier," according to Arone. The 10-year Treasury yield had decreased, and the currency was weakening, he added, implying that highly speculative, volatile equities are ceding leadership to firms that profit from increasing rates and inflation.

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In the previous week, the energy sector was the single winner among the S&P 500's 11 sectors, while materials and consumer staples outperformed.

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The Dow Jones Industrial Average DJIA, -1.02% fell 3% last week, taking its year-to-date loss to 1%, while the S&P 500 SPX, -1.05% fell 2.7% and the tech-heavy Nasdaq Composite COMP, -1.69% down 1.7%. The Nasdaq's year-to-date gain has been reduced to 8.9%.

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According to Goodwin, equities might fall another 10% to 15% if the country enters a recession. She stated that while earnings reports revealed that the IT and consumer discretionary industries' bottom lines are holding up rather well, top-line sales are slowing – a concerning mismatch. Companies are struggling to sustain profit margins outside of pandemic winners, she observed.

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According to Arone, margin issues might be the next major concern.

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Net margins are lower than the five-year average because companies have reached a point where they can no longer pass on price increases to customers.

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"In my opinion, this will continue to be a headwind for the outlook for equities, and one that is flying under the radar," he added. It might explain why sectors with strong margins or the ability to improve margins, such as the aforementioned energy and industrials, outperformed the market after the week.

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