The full impact of Federal Reserve tightening has yet to be felt, and a pause isn’t likely to negate the slowdown ahead.
Shawn L. Snyder, Global Market Strategist
Olivia Schwern, Global Investment Strategist
Our Top Market Takeaways for January 13, 2022.
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 in December for the sixth consecutive month.
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 was 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 overhired 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 our view.
1. Inflation is trending in the right direction. The latest 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 such as the ISM Prices Paid Index suggest lower levels of inflation ahead.
EXCLUDING SHELTER PRICES, SERVICES PRICES LOOK SET TO DECLINE
ISM Services price index & U.S. core CPI less shelter, YoY, %
This chart shows ISM services and Core CPI less shelter prices from January 1998 until March 2022. The first data point came in at 1.9% for Core CPI less shelter prices and 52.5 for ISM services. From there, ISM services rose to 68.6, while Core CPI less shelter prices reached 5.7% by April 2000. From there, both declined and then rose to back to 60.5 and 4.5%, respectively. Here, ISM services declined a bit before rising to 83.5 by September 2005. Meanwhile, Core CPI less shelter prices rose to 5.8% by April 2005. From there, both fell to 60.1 for ISM services and 1.9% for Core CPI less shelter prices, respectively, by April 2006. Here, Core CPI less shelter prices rose to 6.1% before dropping back to 0.3% by October 2008. Meanwhile, ISM services rose before dropping to a trough of 36.1 by December 2008. Then Core CPI less shelter prices surged and stayed relatively rangebound between 1% and 2% until April 2020, then skyrocketed to 7.3% by March 2022. Meanwhile, ISM services rose to 70 by January 2011 before slowly declining to 50.7 by March 2020. From there until recently, ISM services rose to 84.6 before declining to 67.6.
2. 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.
THE CASE-SHILLER HOME PRICE INDEX SIGNALS LOWER SHELTER PRICES AHEAD
National Case-Shiller Home Price index & U.S. CPI: Shelter prices, YoY%
This chart shows the Case-Shiller National Home Price Index, and the CPI shelter prices from January 2000 until October 2022. The first data points for the Home Price Index and CPI shelter prices came in at 7.9% and 3.8%, respectively. From here, home prices slowly rose to 14.4% by October 2005, while CPI shelter prices dropped to 1.9% before rising back to 4.3% by September 2005. From here, home prices dropped to a trough of -12.7% by March 2009, while CPI shelter prices reached -0.7% by November 2011. Then CPI shelter prices rose to 3.3% by September 2018, before declining to 1.5% by September 2019. From there until recently, CPI shelter prices rose to 7.5%. Meanwhile, home prices rose to 10.4% before declining to 4.4% by June 2020. From there until recently, home prices rose to 20.8% before declining to 9.2%.
3. 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 hike 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 Fed does not want financial conditions to loosen prematurely with inflation still well above target, so it needs to talk tough. Financial markets, on the other hand, are forward-looking and are attempting to forecast policy, not prescribe it.
MARKETS ARE PRICING IN RATE CUTS IN 2023
Fed funds rate and market expectations, %
This chart shows the fed funds rate from 2014 to November 2022. It began at 0.25% and rose to 2.5% by December 2018. It fell back to 0.25% by March 2020, then started rising again in March 2022. It reached 4% by November 2022. The chart also shows market expectations for YE 2023, which shows a peak of ~5% before declining to 4.4%.
4. 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 two 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 United States later this year, but there is at least some chance that the economy remains resilient and experiences “no landing” at all.
INFLATION CONTINUES TO FALL WHILE THE LABOR MARKET REMAINS RESILIENT…FOR NOW
U.S. Misery Index (CPI YoY percent change plus the unemployment rate).
This chart shows the U.S. Misery Index from January 2017 until December 2022. The first data point came in at 7.2. From there, it fell to 5.2 by September 2019 before rising to 5.9. Here, it rose to 15 by April 2020. From there, it declined to 7.7 before rising back to 11.3 by June 2021. From there until recently, it rose to 12.7 and then declined to 10.
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 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 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.
Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a basket of the 100 largest, most actively traded U.S companies listed on the NASDAQ stock exchange. The index includes companies from various industries except for the financial industry, like commercial and investment banks. These non-financial sectors include retail, biotechnology, industrial, technology, health care, and others.
The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index is a composite of single-family home price indices for the nine U.S. Census divisions and is calculated monthly. It is included in the S&P CoreLogic Case-Shiller Home Price Index Series which seeks to measure changes in the total value of all existing single-family housing stock.
The U.S. misery index is an economic indicator that combines the unemployment rate and the inflation rate.
ISM Manufacturing Prices Paid is one of the diffuse indicators, based on which the Supply Management Institute calculates the Manufacturing PMI. It reflects a change in prices paid by industry representatives for the products or services they receive. The index calculation is based on data collected from a monthly survey of supply managers from 18 US industries. Respondents estimate prices paid in the production process: whether they have grown, fallen or have not changed. The collected data are processed and compiled to a diffuse index. The index weight in the total manufacturing PMI calculation is 20%.
All market and economic data as of January 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.
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