Quite the reversal this week as the beloved “Santa Rally” was quickly halted as the modern-day Grinch, Jerome Powell, signaled for tighter monetary policy in 2023 following Wednesday’s 50 basis point increase in the Federal Funds Rate. Market participants quickly realized that Chairman Powell was the Grinch dressed in Santa’s outfit. And while I hate to be seen as the Ebenezer Scrooge of this story, I agree with Chairman Powell’s continued increase of the Federal Funds Rate.
Over Coffee with Andrew today, I want to highlight our rationale on why we still believe the Federal Reserve has a bit more work to do on the inflation front, as well as provide highlights to our current assessment of the slowdown.
Inflation is a phenomenon that many economists claim to understand but have yet to fully appreciate its unruly behavior. Keep in mind that the Federal Reserve basically pleaded to us all that inflation was a non-starter in 2021. Presumably, the people at the Fed are the smartest people in the room but yet blundered the assessment on inflation which now sits at decade highs. I don’t fault them. I realize that inflation metrics come in many forms and can be catalyzed through a multitude of channels. But their ever-so-confident attitude has now left all of us experiencing one of the worst destructions in purchasing power in decades. So, although inflation has moderated its momentum, prices are still increasing at 7.1%. We must be mindful though, that the [grinch] is in the details.
Over the last couple of years, over our coffee together, I have postulated that the seismic shift in labor dynamics would ultimately be the kindling that ignited a sustainable rally in inflation. Yes, we can all argue it was the supply chain bottlenecks but that merely masked the underlying issue: the lack of labor supply due to COVIDs Great Retirement, which led to competitive bidding of talent. This, in turn, has left Core Services Inflation (the inflation that matters most) actually accelerating rather than decelerating like the mainstream inflation metrics. If you recall, I have stated that the ultimate end to this tightening cycle will be a meaningful deterioration in employment. Let me explain why…
The Consumer Price Index (CPI) is the widely used metric for inflation, which measures the price levels of a basket of goods in our economy. It is a useful metric but since it contains a plethora of volatile priced items, it is helpful to remove them to get a core/stable reading. Removing food and energy components helps alleviate this, to a degree. Taking this further, what we know is that 73% of Core Inflation stems from services which are accommodation, recreation, etc. This Services Inflation has an impressively strong correlation to the growth rates of labor costs which seems intuitive; the more our wages go up, the more we spend on services such as travel and dining. The above-discussed labor tightness has created a talent bidding war, leaving us with Sticky and Icky Services Inflation. This critical issue was finally highlighted by Chairman Powell on Wednesday with stating that core inflation (less housing) has not seen a material improvement thus the need for tighter monetary policy.
The tight monetary policy will (and already has) lead to higher unemployment. As unemployment moves higher, inflation moves lower, thus suspending any future rate hikes. As of this week, we have seen several layoff announcements, which is adding to jobless claims, which began rising in October. Which now requires investors to be prepared that the story for 2023 wont just be about inflation but more so the destruction inflation has had on corporate profits thus the necessity of layoffs. This was evident in Tuesday's price action of the S&P 500 as markets erased almost 2 percentage points following the inflation report which showed deceleration.
The deceleration in inflation momentum was a welcome sign to the capital markets… initially. The S&P 500 erased almost 2 percentage points from its open as investors began to realize that this level of deceleration is most likely stemming from an abrupt pullback in demand. In short, demand is slowing rapidly. We can corroborate this thesis with the latest decline in weekly retail sales (Redbook) and a profit warning from JetBlue regarding the overestimation of demand. The reality is that 2023 will not be the story of inflation but the realization that the economy is slowing much quicker than anticipated. Many economists are predicting a recession at the end of 2023. The tail risk is that it materializes much quicker. Keep in mind that risk assets have NOT priced in recession yet. Therefore, any material slowdown in COINCIDENT economic data will impact risk assets.
DCA base case has been the following:
We entered the year expecting employment rates to begin to show signs of stress in October.
This has materialized as continuing claims have begun to accelerate in early November
We expected the Federal Reserve to begin a quasi-pivot via slowing of rates by December
Inflation data reported shows this to materialize. We will know more today after the FOMC press release and conference.
We expect the US (globe) to enter recession mid-2023 with risk assets bottoming sometime before the official recession date
Regarding our expectation of a recession rather than a soft landing (data since the 1940s):
The percentage of yield curves inverted over 55% has led to a recession EVERY time. Today this number sits at 86%
The Conference Board LEADING Economic Indicator Composite is at -2.7%, which has led to a recession EVERY time
The Philly Fed Coincident Index at -4 (one-month diffusion) has led to a recession EVERY time
With the recession expectation, it is important to note that the S&P 500 bottoms roughly six months before the recession.
If economist expectations of recession hold true for end of year recession, the S&P 500 will bottom in the summer
If we expect a recession to come by the summer of next year, risk assets are likely to bottom at some point in Q1
Statistically speaking, the S&P 500 has a q4 “Santa rally” of 12.14% every time the S&P 500 was down 10% or more through the first three quarters of the year. As of the last couple of weeks, we have hovered around 13.2%
With the S&P 500 already above the likely outcome for the year-end rally, any further gains may be given back before year-end.
We have continued to maintain elevated cash weights and defensive growth tilts to mitigate a good portion of this year's drawdowns tilts but will begin allocating into risk-off assets such as treasuries as employment and economic data report negative growth rates at an accelerated pace.
Before we all enter the holiday stretch, I want to not only thank each and every one of you but also say thank you to our clients. This has been the worst start to the stock market in 50 years and the worst bond market in 70 years. That is no easy pill to swallow, as wealth destruction has occurred in every asset class except cold hard cash. This was one of those years where patience prevailed. We believe the DCA financial and wealth planning process has helped serve as foundational support during this financial journey.
Please do not hesitate to contact me with any questions or comments.
Best,
Andrew H. Smith
Chief Investment Strategist
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