By Ellen Hazen, CFA®, Chief Market Strategist
January 6, 2023
December / Early January Takeaways:
- The November Consumer Price Index (“CPI”) was +7.1% year-over-year, down from +7.7% in October
- Both November and December jobs reports were strong. In both months, new jobs were well over 200,000 and unemployment remained in its recent 3.5-3.7% range
- The Federal Reserve (“Fed”) raised the Federal Funds rate by another 0.50% at its mid-December meeting, from 4.0% to 4.5%. In 2022, the Fed increased the overnight rate by 4.25%, the fastest increase in several decades
- Rates rose across the curve, with the 10-year rate increasing by nearly a quarter of a point during the month. This led to a modest decline in fixed income returns for the month. For the year, the Bloomberg US Aggregate Index declined by over 13%, the worst performance in years
- Equity markets eased after the 14% rally from mid-October through the end of November. In December, the S&P500 declined by 5.8%, ending the year with a 18% decline. Value stocks continued to outperform growth stocks with a 3.5% differential, continuing the year-long trend. Small companies, however, underperformed large companies, as visibility into the timing of an economic recovery remained elusive
What We Are Watching in January:
- The Fed will meet at the end of the month, announcing its decision on Feb 1. Currently, markets are pricing in an additional one-to-two 25-basis point increase at the Jan-Feb meeting for a target rate of 4.6%
- Companies will start reporting Q4 2022 earnings results in the second week of January
- CPI for December will be reported on January 12
- We will see how much the economy grew in the fourth quarter of 2022 when GDP is reported on January 26
The key variables everyone is watching are the same ones the Fed is watching: inflation, jobs, and growth.
We expect that earnings estimates for 2023 will be meaningfully reduced as we work through earnings season. Many companies opted not to provide 2023 earnings guidance when they reported Q3 earnings, citing lack of visibility, but they will not be able to avoid doing this when reporting year-end results. Q4 earnings expectations have declined by a bit over the past month, from a 1% decline to a 3% decline, so expectations for softer earnings are beginning to seep into investors’ psyches. Earnings estimates for 2023 have also declined from 6% growth assumed a quarter ago to only 2% growth now. We believe 2% may still be too high and expect that earnings may very well be lower in 2023 than in 2022.
In this market environment, we are investing in high-quality equities and high-quality fixed income. Continued volatility may provide opportunities for tactical repositioning as economic clarity increases.
Inflation Has Moderated but Remains High
The first half of 2023 looks decidedly murky, as a strong labor market is counterbalanced by high inflation and evidence of a slowing industrial economy. The markets are (even more than usual) attuned to the utterances of Fed officials, as investors seek to discern how far the Fed will continue to tighten monetary conditions in order to quell inflation. We believe the Fed is facing a fundamental dilemma. Its formal mandate is to manage toward both full employment and price stability. (It also has an informal mandate to maintain stability of the financial system.) Price stability is measured by inflation – the Fed’s preferred measure is the Personal Consumption Expenditure Index (“PCE”), while the market also examines the CPI. The Fed has communicated its explicit target as 2% core PCE.
The Fed has raised its short-term benchmark rate by 4.25% over the past nine months and is widely expected to increase the rate by at least another quarter of a point at the January-February meeting. The entire yield curve has responded: the 10-Year Treasury Bond yield has increased from 2.14% just before the initial hike to 3.6% now. This is what the Fed wants: tighter financial conditions across the yield curve should slow the economy. And indeed, we have seen material slowing in interest-rate-sensitive areas of the economy, including autos and housing.
Inflation, though, has only softened a bit. CPI peaked at 9.1% in June 2022 and has declined to 7.1% in November. (PCE has exhibited similar dynamics). With so much Fed tightening, why hasn’t inflation made more progress toward the Fed’s 2% target?
Deconstructing the CPI
Diving into the CPI components in more detail illuminates part of the answer. CPI is subdivided into many components, including goods and services (for core CPI) as well as food and energy (for reported CPI).
Referencing the CPI composition chart (shown above), we can see that Energy (green) has been declining as a contributor to CPI for some time. Food (orange) spiked higher after Russia invaded Ukraine and has continued to contribute to CPI, although it has stabilized and is no longer increasing. Goods (excluding Food and Energy, red) has responded rapidly to the Fed’s tightening of financial conditions, contributing only 0.8% to the November CPI reading. This is a significant decline from the 2.4% it contributed in February of 2022, right before the Fed’s initial rate increase in March.
The problem, as is apparent from the chart, is Services (excluding Food and Energy, blue). Services had been a stable 0.75% to 1.75% contributor each month for the past several years, until mid-2021, when the US began to exit the COVID pandemic shutdown in earnest. Since then, Services has steadily increased and contributed over 3.9% to the November CPI reading.
Services inflation does not respond to interest rate increases, as it is primarily driven by wages. Wages in turn are in part driven by the number of available workers. As can been seen from the next chart, labor force participation (the percentage of the population that is either working or looking for work) has not yet returned to pre-pandemic levels.
The Fed’s Dilemma
Thus, the Fed faces a dilemma. It is charged with providing price stability, yet its primary tool – short-term interest rates, and to a lesser extent, long-term interest rates – does not readily translate into the ability to manipulate/manage the labor market. Because the economy is increasingly a services economy, and not a goods economy, the Fed is stuck.
Various Fed officials have made it clear that they do not wish to repeat the errors of the 1970s, when, after an initial tightening cycle had brought inflation down, Fed Chair Arthur Burns prematurely eased financial conditions and inflation came roaring back. Yet, in the 1970s, Services was less than 40% of the CPI weighting, as compared to nearly 60% today. Thus, the lesson that higher rates then would have successfully cooled inflation is not as apt today.
The US economy will remain in limbo for a while |
As a result, we expect that the US economy will remain in limbo for a while. As long as the labor force participation rate does not increase, and there is no pressure release valve from any change to immigration policy, labor will remain constrained, wage pressure will continue, and services inflation will likely continue to drive inflation stubbornly above the Fed’s 2% target. The Fed will respond by keeping financial conditions fairly tight, not wanting to repeat the mistakes of the past. In so doing, it may – as parents so often do when raising their own children – avoid the mistakes they are determined not to repeat and instead simply make new ones.