The much-anticipated Consumer Price Index (CPI) report was released last Thursday, January 12 and reported a 0.1% decline in headline CPI for December. This was the first monthly decline in two and a half years! While seemingly small, markets reacted positively as the decline signaled abating upward pressure on inflation. In a win for market analysts, the report matched expectations very closely and signified that the Federal Reserve’s war on inflation could be working. Also reported on Thursday was unemployment data, with claims falling by 1,000 and continuing claims declining by 63,000 for the second week of January. This is significant because it shows that the labor market is holding strong; and when coupled with still-elevated inflation, this indicates that the Federal Reserve will remain committed to a restrictive monetary policy along their tightening path. Soon after the CPI and unemployment reports, the Bloomberg World Interest Rates Probabilities (WIRP) data showed the market pricing in a 0.25% rate hike for the next FOMC meeting on February 1. Correspondent to this market data, Federal Reserve Bank of Philadelphia President Patrick Harker said that he “expect[s] that we will raise rates a few more times this year.” Harker’s statement suggests that the days of 75 basis point rate hikes are largely in the past and indicate a slowing of the Federal Reserve’s rate hikes. The likelihood of smaller hikes, likely 25 basis points, will be appropriate moving forward, and the market is in agreement, as shown in the chart below. The market is pricing an over 95% probability of the Federal Reserve raising rates by 25 basis points on February 1.
December 2022 Stonemark Market Commentary
All Eyes on the Fed
2022: A Challenging Year
The term “inflation” re-entered the lexicon in 2022 as it rose to levels not seen since the 1970s. This return of inflation was driven by many factors but can be attributed to increased demand and restricted supply. More precisely, as former Fed chair Ben Bernanke writes in his macroeconomics textbook with Andrew Abel: “Inflation occurs when the aggregate quantity of goods demanded at any particular price level is rising more quickly than the aggregate quality of goods supplied at that price level.” The reason demand outpaced supply occurred largely due to 1) supply shocks, 2) increases in the money supply, and 3) tight employment markets driving up wages.
The year of 2022 saw normalization of widespread supply chain issues, driven by countries and economies reopening, which helped return products to shelves. While supply chain issues are still persistent, 2022 saw a more normalized supply of goods and services that helped slow inflation in the fourth quarter of the year.
Another cause of inflation is an elevation of the money supply, which can be measured by the St. Louis Fed’s “M2” indicator. The St. Louis Fed chart below shows that after the meteoric rise in money supply beginning in 2020, the money supply started to fall in 2022 and is continuing to fall into 2023. The Federal Reserve's rapid increase in interest rates, coupled with an exodus from Quantitative Easing (QE) and a return to Quantitative Tightening (QT), has shrunken the Federal Reserve’s balance sheet and dried up excess liquidity in the markets. We expect this reduction in the money supply to continue in 2023, as the Federal Reserve remains committed to holding rates at an elevated level and to Quantitative Tightening.
Inflation also increased as a result of wages being driven by an exceptionally tight labor market. The forces of supply and demand took hold in the labor market throughout 2020, 2021, and into 2022, with the demand for workers far outpacing the supply of available workers. As such, when demand is greater than supply, prices increase, and inflation inevitably follows. However, 2022 bore witness to massive interest rate increases that brought mortgage rates up and caused real estate and mortgage markets to begin layoffs in their workforces during the middle of 2022. The next leg of layoffs occurred in companies that saw outsized growth due to the pandemic, such as Zoom and Peloton. These companies rapidly increased their staff counts in the second half of 2020, throughout 2021, and into the beginning of 2022. With a restrictive monetary environment and an overall lack of liquidity, these once-profitable companies began reducing headcounts in 2022 and will likely continue to do so in 2023.
The fourth quarter of 2022 saw an acceleration of layoffs in technology and financial companies, as the impact of interest rate increases began to take hold across the broader market. However, these layoffs have not yet materially reduced wages, which is a key component of inflation and has complicated the overall macroeconomic picture. The chart below from the U.S. Department of Labor shows for the week ending January 14, seasonally adjusted initial unemployment claims were 190,000—a decrease of 15,000 from the previous week's unrevised level of 205,000 claims. The 4-week moving average was 206,000 claims—a decrease of 6,500 from the previous week's unrevised average of 212,500 claims. To see material decreases in persistent inflation, continued layoffs will have to occur to reduce upward wage pressures. This phenomenon is likely to occur in 2023 as tightening continues to work its way through markets, causing elevated layoffs.
2023: Navigating Through the Fog
Overall market consensus is that the U.S. will face a recession in the coming 12 months, but the severity and duration of the aforementioned recession remains hotly debated. Inflation is notoriously difficult to tame, and it could prove to be elusive in returning to the Federal Reserve’s target of 2%. We believe inflation in the U.S. has peaked and should continue decelerating throughout 2023. If 2023 earnings miss current expectations and guidance is revised, it is difficult to see expensive, growth-oriented stocks be an attractive investment opportunity in 2023. In this choppy market environment, we maintain a bias towards value and profitability, as stable earnings, cash flows, and balance sheets will continue to hold up well in a tumultuous economic environment. Additionally, we see opportunity in fixed income markets, with newly elevated interest rates providing attractive yields and solid coupons. We expect the Federal Reserve to continue raising rates in the first half of the year before pausing near the end of the first quarter, which could lead to a modest rate rally and a more normal yield curve. We favor corporate issuers of bonds with strong fundamentals and resilient balance sheets, and we also see opportunities in real assets and commodities as risk diversifiers. We encourage investors to consult with their advisors to see if initiating or expanding fixed-income exposure would suit their situation.
What it All Means
The health of an economy can be judged by the sum of all products and services produced by a country. The United States saw an increase of 3.2% in GDP for the third quarter and current estimates for the fourth quarter come in at 4.1%. The chart below shows the current volatility of U.S. GDP quarter over quarter, with future GDP prints following suit.
Overall, 2022 GDP numbers were relatively flat and fell from prior GDP numbers in 2020 and 2021, indicating a “less healthy” economy from prior years. Nonetheless, the reversal of the negative trend in Q1 and Q2 of 2022 to a positive print in Q3 is promising that conditions may not be as negative as previously forecasted. The current inflation levels necessitate a stronger GDP to mitigate the severity and duration of the likely recession ahead. Markets are in a current state of limbo, anxiously awaiting economic data and Federal Reserve policy decisions. We do not foresee markets in 2023 being as rough as in 2022; but the markets may still be tumultuous and will require a disciplined approach and resiliency. With current GDP expectations, we continue to favor value stocks over growth stocks and quality companies with stronger earnings, cash flows, and balance sheets. Fundamental and valuation-driven investors may want to take a closer look at U.S. small-cap stocks, which are discounted versus large caps and historical averages. Outside the U.S., we see international equities in both developed and emerging markets currently offering attractive earnings multiples and yields relative to comparable U.S. equities.