Inflation cools but is growth next?
The full impact of Fed tightening has yet to be felt, and a pause isn’t likely to negate the slowdown ahead.
Our Top Market Takeaways for January 13, 2023
Market update: The Climb
Stocks rallied and bonds saw gains on the heels of the latest U.S. inflation reading. Both headline and core (ex-food and energy) prices cooled for the sixth consecutive month in December.
Inflation prints have been a big driver of markets over the last year, with stocks popping on softer prints and sinking on hot prints. For instance, the S&P 500 saw a single day rally over +5% in October, with one of the first signs of cooling prices, and fell more than -4% in August, when prices soared above expectations. These two days ended up being the best and worst days of 2022.
This time around, the S&P 500 gained +0.3%, nearing the 4,000 mark unseen in a month, and the growthier Nasdaq 100 outpaced, up +0.5%. Broad international equities also continued their year-to-date climb on the prospect of China’s reopening story, coupled with a milder than expected winter in Europe. Even bitcoin popped over +7%.
U.S. Treasury yields slumped and prices rose as investors grew optimistic that the Federal Reserve is approaching the finale of the tightening cycle. We think this print seems to support a 25-basis-point rate hike at the Fed’s February meeting, with perhaps another hike in March before it takes a pause.
The effects of the hikes we’ve already seen continued to reveal themselves in the real economy this week. The latest: BlackRock announced it is letting go of 500 employees, or around 3% of its total workforce, given the “unprecedented market environment.” This news followed that of Coinbase, which plans to reduce its headcount by roughly 20%. It is worth noting, however, that layoffs have so far been contained within the rate-sensitive financial and tech sectors that likely over-hired last year. U.S. Q4 2022 corporate earnings season also kicks off this morning, which will provide further insight into how businesses have been faring.
Now, back to the main event (and before Friday the 13th turns the story around for us):
Spotlight: Observations from the CPI report
Inflation fell as expected in December… that is uniformly good news.
We expect the downtrend to continue, but the question is just how much further inflation will fall. The answer will likely impact both central bank monetary policy and financial asset performance in the year ahead.
Here are our thoughts on the data and what it might mean for the view.
- Inflation is trending in the right direction. The latest Consumer Price Index (CPI) print showed that economy-wide prices fell by -0.1% in December. And while headline prices are 6.5% higher than one year ago, we have seen significant cooling from inflation’s peak level of 9.1% in June 2022. Weeding into the details, falling energy prices more than offset a rise in shelter prices (energy prices fell 4.5% in the month, while shelter prices rose by just 0.8%).
The core measure, stripping out food and energy, accelerated 0.3% on the month (versus +0.2% in November) but softened to a 5.7% pace (from 6.0% prior).
Overall, while inflation remains above the Fed’s mandate, the slowdown is encouraging and sentiment surveys like the ISM prices paid index suggest lower levels of inflation ahead.
- Even shelter prices look set to decline. Home prices have already begun to cool as higher mortgage rates have weighed on housing activity, and new asking prices for rental leases are moderating. While the shelter component of the CPI is likely to remain elevated for some time, signs suggest that even this component (which accounts for nearly a third of the CPI) should come down in the year ahead.
- Markets don’t believe the Fed. The next Fed meeting is on February 1, and the central bank is widely expected to downshift from its last 50-basis-point rate hikes to a 25-basis-point rate hike. Looking beyond the next meeting, the Fed continues to signal that it intends to keep rates higher for longer, but financial markets expect rate cuts by the end of 2023. While some financial pundits seem confused by the disconnect, we believe it makes sense. The Federal Reserve does not want financial conditions to loosen pre-maturely with inflation still well above target, so they need to talk tough. Financial markets, on the other hand, are forward-looking and are attempting to forecast policy, not prescribe it.
- Things seem less miserable. The misery index, which adds the inflation rate to the unemployment rate, has been gradually coming down since June 2022 as headline inflation has fallen by over 2 percentage points while the unemployment rate remains extremely low at 3.5%. Combined with the sudden reopening of China, this seems to be reviving some degree of investor optimism, with the S&P 500 having stealthily rallied over 10% since mid-October 2022. Leading U.S. economic indicators continue to validate our base case call of a recession in the U.S. later this year, but there is at least some chance that the economy remains resilient and experiences “no landing” at all.
The bottom line: The good news is that inflation data are trending in the right direction. The bad news is that the full impact of the Fed’s recent tightening cycle has yet to be felt. An eventual pause from the Fed will probably be seen as a positive catalyst for risk assets once it occurs, but it likely won’t negate the economic slowdown ahead. Investors should expect more market volatility in the first half of 2023, but we remain optimistic that market sentiment will improve in the back half of the year as investors price in an eventual economic recovery in 2024.
We think that periods of relative market calm can be used by investors to review their portfolios.
- Equities: This could be a good time to reassess exposures and make sure that you have a proper balance between sector, style, size and geography, or to hedge exposures through options, structured notes or managed strategies.
- Fixed income: We still think that high quality parts of fixed income markets provide an attractive entry point, especially for those looking for a buffer against potentially adverse economic outcomes.
- Borrowing: We still think that over the medium-term, interest rates should head lower, but mortgage rates have come in, and there could be some opportunities to hedge other liabilities.
At the same time, we are always looking for opportunities across markets. Small- and mid-cap equities, preferreds, and dislocated market segments such as semiconductors are among our more tactical areas of focus. Investors could be well-served thinking through ways to not just protect their portfolios in the event of recession, but also to position for the recovery that could come after.