Priced for Goldilocks
Mark Luschini, Chief Investment Strategist
The New Year has started off with a bang as stocks, and risk assets in general, rally sharply.
Currently, the question that needs to be answered is whether these gains are justified? In our Outlook 2023 report, we posed an optimistic scenario in which substantial gains could occur this year if inflation recedes rapidly and the U.S. averts a recession. This outcome requires that the Federal Reserve avoid tightening monetary policy to the point of choking economic activity. It also demands that the labor market—the support for households and a driver of consumption—does not weaken so much as to cause consumers and businesses to retrench.
These requirements are a tall order given the historical propensity for policymakers to blunder by holding rates too high for too long, inadvertently causing a recession as a result of their effort to thwart inflation-inducing demand.
We believe, however, that the end of the rate-hiking cycle is near. While we do not yet judge aggressive positioning as warranted, maintaining a target weight to equities in a balanced portfolio individualized to one’s risk budget is sensible.
Looking for a Fairy Tale Ending
A “Goldilocks” outcome is possible but is it probable?
Unfortunately, it may require some time to pass before the likely path for the economy and markets emerges. As of today, while we are encouraged by recent developments on the inflationary front, prices have not yet fallen near to the Federal Reserve’s explicit target of 2%. Meanwhile, monetary officials have continued to raise interest rates to a level that by their own admission is in restrictive territory.
Therefore, not only will future rate increases, should they occur, serve to further hinder growth but it’s arguable that what the Federal Reserve has already done makes an economic contraction sometime later this year highly probable. Referring again to our Outlook 2023 report, we advanced a base case in which we experience a mild recession in the second half of the year, but stocks look through to the green shoots that inevitably sprout following a slowdown, catalyzed by the Federal Reserve shifting policy to a more accommodative stance. If that forecast comes to fruition, that should in turn, lead to moderate gains in the stock market.
For the time being, market participants could be disappointed that a shift in policy is not forthcoming. Markets expect the Federal Reserve’s rate-hiking campaign to not only end soon but pivot to cutting rates shortly thereafter. Monetary authorities, at least so far, do not see the evolution of inflation allowing for such a pivot in their rate-setting forecasts. The reconciliation of these disparate views may produce volatility and put pressure on stocks that have advanced on the notion that “Goldilocks” will be achieved.
We believe investors may be a tad too sanguine regarding the prospects for economic growth and earnings. Economic data have showed myriad signs of softening activity and forward-looking indicators are eliciting troubling signals for prospects in the months ahead. Earnings have already begun to be trimmed for this year, with many companies reporting year-over-year declines especially outside the energy patch.
Certainly, the January rally in risk assets celebrated falling inflation and the prospects for rates to stabilize. However, we see the premise for this rally being challenged soon as investors switch their attention to disappointing earnings growth, mounting signs of economic slowdown, and a general realization that perhaps such euphoric aspirations are premature.
This is not intended to cast a bearish pall over our market outlook. Rather, we believe vigilance is critical in the next few months. Stay tuned.
Four Key Issues for 2023
Guy LeBas, Chief Fixed Income Strategist
Following our tradition for the second Investment Perspectives of the year, this article outlines four key issues likely to dominate market conversations in 2023.
At the beginning of 2022, we identified inflation (“fade by mid-2022”), peak fed funds rate (“a contractionary 3-4%”), supply chain (“turn shortages into a glut”), and pension flows (leading to “liftoff to long-term rates”) as the factors most likely to affect fixed income, and they did not disappoint. Of these issues, we concluded “risks of the top issues largely skew toward the downside for fixed income returns,” and with the bond markets posting their worst return in contemporary history, that skew was correct.
This year, however, the risks skew to lower interest rates and higher returns, as our four key issues for 2023 are about economic downsides.
One frustration for the Fed is, despite rate increases, job markets remain resilient. Milton Friedman famously quipped that monetary policy was subject to “long and variable lags,” meaning that it is hard to know when rate hikes will impact economic activity.
In 2022, there was no shortage of Fed-sponsored research arguing that those lags are now short, as markets convey interest rates to the real economy quickly. The upshot is that many policymakers think their rate hikes have already hit the economy. But history suggests that natural delays in how firms and consumers act mean we have yet to feel the downside from said hikes and won’t until the economy is already in a housing-led recession. While not our base case, if the Fed has committed a policy error by underestimating lags, that error would force long-term interest rates lower.
Inflation in 2021 and 2022 was about three things coming together in a nasty brew:
- demand shock from wild swings in consumer preferences,
- supply shock from resource constraints, and
- unprecedented fiscal stimulus.
All three of these factors seem to be normalizing. Consumer preferences have stabilized into a post-COVID economy; global manufacturing is through the period of shortages; and excess savings built in part through fiscal stimulus have, for better or worse, liquidated. Core goods prices have already been falling for several months, and if rents continue to stagnate, the core CPI could end up running below 2% by late 2023, forcing a reckoning between disinflationary trends and recent high inflation.
Chart 1: Inflation is Decelerating: “Super Core” is Running Below 0%
Our view remains that a recession is likely in mid-2023, although given the highly variable economic crosscurrents, it is impossible with normal models to evaluate how deep or long that recession might be. It is also very possible that a 2023 recession is oddly narrow, isolated to only interestrate-sensitive sectors like housing and autos. Given the 2022 decline in home construction, we would have already expected roughly one million construction job losses. But there have been net gains over the last year. The chance of a narrow recession spilling over into the broader economy is largely contingent on whether residential and commercial builders end up laying off employees in the face of lower sales.
Chart 2: Home Construction is -12% but Construction Jobs are +3% Since January 2020
Credit spreads widened in 2022, peaking in late summer before retrenching somewhat. By contrast, fundamental measures of corporate credit quality among public companies—leverage and liquidity—were near their all-time bests going into 2022 and, so far, appear to have improved during the year (we won’t know for sure until 4Q earnings season winds down).
The only conclusion, therefore, was that weaker credit markets in 2022 were a function of reduced participant confidence. As analysts, we are better equipped to evaluate fundamentals than confidence. But much of the credit market performance for the coming year hinges on market confidence—a matter that we can only monitor in real time.
As January Goes... Sometimes
Gregory M. Drahuschak, Market Strategist
One of the oldest stock market axioms contends that the results in January foretell how the entire year will fare.
From 1950 through last year, this theory was correct 48 out of 73 years. Since 2000, this has been correct only 12 times. Three trading periods together, however, offer a potentially more reliable gauge of market potential.
Chart 3: January and Full Year % Result for S&P 500 - 2000 through 2022
The Stock Trader’s Almanac found that if the market posts gains during the Santa Claus rally period (the final five trading days of a year and the first two of the following January), the first five trading days of January, and the entire month of January, the stock market is positive during the next 11 months 87.1% of the time, with an average gain of 12.3%. Meanwhile, the full year was positive 28 of 31 times (90.3% of the time) with an average gain of 17.5% in all years.
When this triple winning streak follows a year that had a bear market low, the market has ended higher in all the 13 times when this condition existed since 1949, with gains ranging from as much as 45% in 1954 to as low as 10.8 in 1971.
As comforting as these data might be, other factors will have more to do with how the equity market fares this month and this year.
Eyeing the Fed
February kicked off with the Federal Reserve Open Market Committee (FOMC) policy statement that included the widely expected 25-basis-point increase to 4.5% and 4.75% for the fed fund target range. As stated in the policy release, “ongoing increases in the target range will be appropriate,” but the bond market did not waver from the belief that the terminal rate in this cycle might be lower than the Fed projects. In response to a question, Fed Chairman Jerome Powell said the Fed is not focused on financial conditions but is solely focused on inflation. This shoved bond rates below where they were before the release, and all three major market indices erased pre-release losses and closed higher, as hope developed that the February rate boost might be the last in this cycle.
Earnings report season technically began in the third week of January, but the season hits full stride this month. The early reports, however, were disappointing.
By the end of January, 29% of S&P 500 companies had reported calendar fourth-quarter results. Sixty-nine percent of these companies reported a positive earnings surprise and 60% reported a positive revenue surprise. Both measures were below their one- and five-year averages. For the final quarter of 2022, blended earnings are expected to be down 5.0%. If this is the final result for the quarter, it will be the first time the S&P 500 has suffered a year-over-year earnings decline since the pandemic-impacted third quarter of 2020.
The 2023 S&P 500 earnings estimate has fallen in 29 of the last 34 weeks and for the last 21 consecutive weeks. This took the estimate down to $221.40, which is only 0.91% above the estimated 2022 outcome. In addition, based on recent data flow, that $221.40 is likely to come down.
This, of course, puts valuation in the center of the market conversation. The present earnings estimate values the S&P 500 at 18.3 times the 2023 earnings, which even in less economically challenged times would not be inexpensive. The range of analysts’ S&P 500 earnings estimates goes from as low as $180 to a level not far from where the estimate is now. The $180, in our view, is too low. What potentially is above this centers on whether the U.S. suffers a recession.
Various conditions presently make it difficult to assume the market can achieve an earnings multiple expansion, which places the burden of stock price appreciation squarely on the outcome of corporate earnings. This is why the current earnings report period is shaping up to be one of the more important ones in recent memory.
The earnings data available as soon as the third week of this month could provide the evidence needed to make a better assessment of the market’s 2023 prospects.
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About the authors
Chief Investment Strategist, President and Chief Investment Officer, Janney Capital ManagementRead more from Mark Luschini
Director, Custom Fixed Income SolutionsRead more from Guy LeBas
Equity Market Analyst, ISGRead more from Gregory M. Drahuschak
March Investment Perspectives
January Investment Perspectives