With the first two weeks of trading for 2023 in the books, and deep scares from 2022 deeply engrained in memory, we are welcoming how this year is starting. Opportunities seem to be presenting themselves in both the fixed-income and equity markets, yet vivid memories of the short-term rallying that occurred a few times last year make investing tentative particularly when economic conditions are far from what could be considered attractive. So, let’s begin with the backdrop of how 2023 is starting vs. how 2022 started:
- At the start of 2022 the Fed was behind the curve of inflation and now it appears that they might have been too aggressive at addressing inflation and longer-term rates are trailing down.
- Besides bond interest rates, measures of inflation are tracking far below the Fed and Consensus, also leading to a recognition that the Fed could be considered “too hawkish.”
- In 2022 the US equity markets started off the box weaker, with the indexes being down over 2% in the first week of trading, whereas 2023 is the exact opposite.
- Per the rule of “first 5 days,” since 1950, when the prior year is “negative” and the first 5 days are over 1.4%+ (actually it has been 7 positive days), equities average +26% gain and higher 70f 7 times.
Logically the next question becomes, “what changed?” The catalyst seems to be the measure of interest rates and how they have been affected by the reported progression in the CPI. Last week’s CPI was expected to be flat to slightly lower and it came in much lower than expected. The consensus was for December Core to have a month-over-month change of +.25%, it came in at -1%. It was also the third consecutive month of lower inflation readings at the consumer level. According to Thomas Lee of FundStrat, “Disinflation (aka “deflation”) is accelerating. A whopping 59% of CPI components are now in outright deflation, so the pace of items “deflating” is also well above the long-term average.”
Besides measures of inflation of the price of goods, the Fed remains focused on jobs and wage rates. These are both also showing signs of easing, and the bond market (interest rates) are reflecting this with longer-term rates declining. With inflation falling faster than what the Fed has expected, this could lead to a slowing in the veracity of rate hikes, and the positive result could be equity prices rising to reflect this.
The current dilemma for the Fed is the ultimate cost to the economy. They are torn between changing their inflation narrative and slowing the speed of rate increases or continuing their stated progression and reversing the economy leading to millions of jobs lost and ultimately a protracted recession. In looking at current interest rates, the bond market believes the Fed will recognize the changes in inflation that are afoot and will slow their rate increases. The new question becomes, “does it make sense for the Fed to continue to stick with its current inflation narrative and thus need to force a rise in the unemployment rate?”
- Arguably, it is far cheaper for Fed to change its narrative.
- Cheaper to accept the descent of inflation than to continue and push the US into a recession.
- This is an important challenge facing the markets.
- “If” the Fed changes, what happens to equity prices?
The path to higher equity prices as a result of the above-mentioned inflation measures seems to be dependent on:
- Core inflation falling faster than Fed and consensus expects (bonds are telegraphing this).
- Wage inflation is already approaching the 3.5% target of the Fed.
- Fed could “dovish” leg-down its inflation view.
- This would possibly allow the financial conditions of a tight economy to ease.
- The bond market, the US Dollar, and foreign markets should continue to directional change they have begun to recognize beginning with the high in the 10–30-year interest rates on 10/21/22.
So, I will end this week’s note with the list of what has been the base case when stocks have gained, as they have, at the start of this year, following a negative year. It is nice to know that 7 out of 7 times, the full-year median gain in the equity markets is +26%. The two most recent years reflecting this were 2012 and 2019.
We will of course be keeping a very close eye on all of these points, but suffice it to say that 2023 is starting to feel quite different than 2022. It doesn’t mean that we aren’t extremely cautious, but we will continue to monitor the markets and the economy to see if “this time is different.”
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