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®
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