December 2022 | Equity Commentary
Published on January 12th, 2023
Strong equity market gains posted from the October lows through November were pared back in December. It appears most of December’s drawdown came after the Federal Reserve’s decision to raise the benchmark fed funds rate by 50 basis points. We believe the issue for financial markets was not the rate hike itself—which was widely expected—but rather the central bank’s new projection for the terminal fed funds rate in 2023. In September, the Federal Reserve was forecasting a peak fed funds rate of 4.6% by the end of 2023, but the December meeting shifted the projection even higher to 5.1%. Investors may have been hoping that encouraging inflation prints for October and November would soften the Fed’s stance.1 The following day, retail sales came in weaker than expected, which may have accentuated Fed-related weakness. The S&P 500 retreated by -5.8% for the month, and US Treasuries ended a challenging year with even more upward pressure on yields across the curve. Stocks did well for the quarter, however, with the S&P 500 gaining +7.5% for the three months ending December 31, 2022.2
The Labor Department’s headline consumer-price index (CPI) measure of inflation rose by 7.1% year-over-year in November, a marked improvement from the 7.7% rate posted in October and a significant decline from June’s 9.1% peak.3 The Federal Reserve’s preferred measure of inflation, the PCE Core price index, also improved, slowing to a 4.7% year-over-year rate in November from 5.0% in October.4 The Federal Reserve responded in December with a 50-basis point rate increase, a welcomed downshift following four consecutive 75 basis point increases. The fed-funds rate now stands at a range between 4.25% and 4.5%, a 15-year high.1
Encouraging inflation readings have yet to align the Federal Reserve with the market, in our opinion, however. Market participants appear to be anticipating a larger decline in inflation in 2023 – and thus a lower expected terminal fed funds rate – than current Federal Reserve projections. The expected inflation gap can be meaningful – according to Barclays, the bond markets are projecting the consumer price index will fall to 2.6% by the end of 2023,1 which would arguably put the Federal Reserve’s preferred PCE price index very close to the 2% target. Meanwhile, the Federal Reserve actually raised its 2023 core PCE inflation forecast from 3.1% to 3.5% at its most recent December meeting.1 Market consternation in late December appeared to be tied to this increasingly divergent outlook on inflation and interest rates.
As we have mentioned in previous months’ commentaries, the Federal Reserve has substantially shifted its focus to services inflation, excluding shelter (housing costs). Chairman Powell’s biggest concern, in our opinion, is the effect the tight labor market has on wages, which in many cases influences companies to raise prices to make up for higher costs. Ongoing tightness in the labor market could cause inflation to become entrenched, which is arguably the Federal Reserve’s biggest fear. In comments following the 50-basis point rate increase, Chairman Powell said, “the labor market continues to be out of balance, with demand substantially exceeding the supply of available workers.” 1Wages and salaries grew 0.5% from October to November5, and prices for services rose over that period while prices for goods declined. We believe the Federal Reserve is not likely to waver from its hawkish stance as long as labor market strength persists, even if goods inflation declines sharply in 2023 as most expect.
The ‘good news’ here, in our opinion, is that aggressive monetary tightening to date has already slowed growth and overall inflation, and because rate hikes work on a lag, is likely to produce more economic weakness in the first half of 2023. Key leading economic indicators such as the Conference Board Leading Economic Indicator index and the OECD leading indicator appear to be at levels that have historically signaled a recession is in the offing. The inverted Treasury yield curve corroborates this view. Purchasing Managers’ Indexes are also declining towards contractionary territory,6 though are not there quite yet.
Housing is another key component of inflation, making up about 1/6th of the Fed’s preferred PCE price index.7 Existing home sales have fallen 32% over the past 10 months, and home prices have also come down from peak levels.7 In the rental markets, the supply of new apartments has hit a 40-year high, and more than 500,000 new apartment units are expected to hit the market by the end of 2023 – the highest total since 1986.7 Rents have fallen from their peaks in many major cities.7
In our view, the effect of slowing economic growth on employment has to date been modest, but not zero. Continuing unemployment claims bottomed near 1.3 million in May 2022, increasing to ~1.7 million by the end of the year, and job openings have come down from a March peak of 12 million to 10.5 million at the end of November.8 These are steps in the right direction, but further declines in job openings are likely needed in the new year for the Federal Reserve to shift its thinking.
Overseas, China made official the end to restrictive “zero Covid” policies, with the state now scrapping rules for mass testing, ending mandatory hospitalization for people who test positive, and reconfiguring how lockdowns are imposed, among other changes.9 We believe these changes are not likely to result in an immediate economic rebound, however, as the loosening of rules comes in the dead of winter when cases and hospitalizations are likely to rise the most. China appears to lack natural immunity from previous infection and also does not have access to highly effective vaccines, which means that even if shutdowns are no longer occurring, de-facto self-imposed lockdowns seem likely to increase as citizens hunker down to avoid infection. Our view is that after a weak first quarter related to the spike in infections, economic activity in China may rebound in the second quarter and more so in the second half, perhaps helped by fiscal stimulus from the Chinese government. If so, this will likely exert a positive influence on commodity prices and growth in other economies as it occurs.
2 Bloomberg Terminal: SPX Index Go TRA
As of December 31st, 2022