Markets are off to a solid start in 2023. With two weeks of the new year in the books, the S&P 500 has picked up just over 4%, and some of 2022's hardest-hit stocks are improving. However, competing narratives are taking shape. Some believe inflation will fall rapidly, and the Federal Reserve will soon pivot to an easier policy stance by halting further interest rate hikes. Others believe the Fed will hold policy in restrictive territory, despite falling inflation, to ensure it stays down. Market participants are busy dissecting economic releases and earnings reports for clues about which path we are on. In time, market leaders will come to reflect the appropriate narrative.

December's CPI report confirmed that inflation is on the decline. Consumer prices increased 6.5% year-over-year and fell 0.1% month-over-month compared to gains of 7.1% and 0.1% for November. Notably, we continue to see substantial moderation in food, energy, and core goods. Service inflation is also anchoring, with wage growth falling to 4.6% year-over-year in December. Still, core service prices are falling slower than hoped, with labor remaining difficult to find. Survey data shows shelter price increases are also stubbornly high despite market rents suggesting a significant easing. Nonetheless, inflation has peaked, and we expect it to continue easing as we move deeper into the year.

The question the Fed is facing is how much further to raise rates. The 1970s showed that backing off rate hikes too soon was a recipe for inflation becoming entrenched. The Fed wants to avoid this at all costs. Therefore, expect at least two more 25 basis point increases in the Federal Funds rate. At that point, rates should be truly restrictive. However, mounting evidence shows that the economy is already starting to slow. Employment remains strong, and consumers are still spending, but survey data from purchasing managers points to a sharp drop-off in economic activity. We are seeing anecdotal reports of layoffs and an increase in credit utilization, which could be early signs of a weakening consumer. The 425 bps of rate hikes in 2022 might be starting to take a toll. Monetary policy acts with a lag, and further rate hikes may add to the severity of that slowdown.

Hopes for a soft-landing rest firmly on the durability of consumers. In an ideal world, job openings fall, but job losses are minimal. With fewer alternatives for job seekers, wage pressure and subsequent price inflation could ease. In this "goldilocks" scenario, GDP and earnings could hold up better than expected and spur markets. The trouble is that the longer inflation persists, the more distant this scenario becomes. Steady progress on inflation must continue.

In a "goldilocks" scenario, it's possible growth stocks were oversold in 2022. Leading up to a recession scenario, we would expect a resurgence in value stocks. Presently, we believe that a mild recession is most likely to occur, which is why we remain tilted toward value stocks. In a highly uncertain economic environment, we lean into companies with strong balance sheets, robust cash flows, and sustainable dividend practices. In time, a return to quality growth may become appropriate. We are on the lookout for those signals. 

Preston May, CBE®
Research Analyst

Donaldson Capital Management's Form ADV Part 2A & 2B can be obtained by written request directly to 20 NW 1st St. #500, Evansville, IN, 47708. Neither the information nor any opinion expressed it so be construed as solicitation to buy or sell a security of personalized investment, tax, or legal advice. This is prepared for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report. The information herein was obtained from various sources. Donaldson Capital Management does not guarantee the accuracy or completeness of information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. Donaldson Capital Management assumes no obligation to update this information, or to advise on further developments relating to it.

This report was prepared by Donaldson Capital Management, LLC, a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information in these materials are from sources Donaldson Capital Management, LLC deems reliable, however we do not attest to their accuracy.

An index is a portfolio of specific securities, the performance of which is often used as a benchmark in judging the relative performance to certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Past performance is not a guarantee of future results. The mention of specific securities and sectors illustrates the application of our investment approach only and is not to be considered a recommendation by Donaldson Capital Management, LLC.

S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.