Throughout the first six weeks of 2023, the S&P 500 has rallied 6.5%, with last year's stragglers leading the charge. Technology and Communications, two of 2022's worst-performing sectors, have picked up 15.9% and 13.9%, respectively. This snapback has been driven by an overarching view among market participants that inflation is declining, and the Fed will soon pivot to a softer policy stance. While inflation has peaked, Fed officials have been careful not to declare "mission accomplished." Last week's blowout jobs report offered a stark reminder that sources of inflationary pressure remain abundant in this economy. Commentary from Fed members and inflation reports over the next few weeks could challenge the market's newfound optimism. 

A sharp decline in the pace of goods inflation over the past year has finally shifted the trajectory of overall inflation lower. Still, services inflation remains a thorn in the side of Fed officials. The U.S. economy added 517,000 jobs in January vs. expectations for just 187,000. This data was noisy, with several factors contributing to an outsized jobs report, but the labor market remains too hot for the Fed's liking. With roughly 1.9 job openings for every job seeker, wage pressure is likely to remain a hindrance to lower service prices. On top of labor market concerns, China is continuing to reopen its economy. If global demand surges and supply chains are further disrupted, we would expect both those factors to be inflationary. A significant amount of government spending is also indexed to inflation, meaning programs tied to 2022 CPI numbers are now doling out more cash. With this backdrop, an argument could be made for a floor under inflation.

Despite these concerns and protests from certain Fed members, investors remain assured that cuts to the Federal Funds rate are in the cards for 2023. Markets expect the Fed to increase rates another 50 bps before reversing course in the back half of the year. At a minimum, Fed officials have made it clear they intend to hold a restrictive policy for some time. In a worst-case scenario, inflation stays elevated, and the Fed is forced to hike rates well beyond market expectations. If this happens, the recent rally in high-multiple equities appears extended. Interest rates have risen sharply over the last several days, and equity markets have resumed a leadership profile that more closely resembles the previous year. 

It is too early to tell who is correct, but it is worth taking note of some subtle longer-term trend changes. Dating back to the October low, many industrial and financial companies have improved significantly. These sectors send a risk-on, or positive, message inconsistent with ongoing recession fears. China's reopening and the enduring strength of consumers are likely responsible. A stronger global economy bodes well for stocks tied to the physical economy. Banks are also extending credit at higher interest rates to consumers who are still showing a capacity to service their debts. Many companies are in a much better position than headlines would have you believe.

Preston May, CBE®
Research Analyst

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