The Week Behind

Despite the benign CPI, the Fed provided a more hawkish outlook than anticipated, catalyzing a multi-session sell-off. Principally, Powell made it clear, while recognizing improvements in inflation data, the Fed will not be satisfied until wage inflation is tamed, which, according to their projections, may require unemployment to reach 4.6% by the end of 2023: a 0.9% increase from today. An increase of that magnitude implies recession. For the week, the DOW fared best, dropping only 1.66%; the S&P lost ~2%; the NASDAQ fell ~2.7%. 

 Highlights

• CPI came in below expectations on both Headline – 7.1% actual v. 7.3% est – and Core – 6% actual v 6.1% est. 
• New Fed dot plots provided a higher terminal rate of 5.1%, which implies 75 bps of hikes for 2023. 
• U.S. Retail Sales fell 0.6% versus the projected 0.1% decrease. This does not bode well for the holiday quarter as it suggests spending was pulled forward into last month.

The Key Narrative Flips: From Interest Rates to Recession

While the Fed stuck to its script, the bond market flipped. The bond market’s reaction to the FOMC, both on the short-end and long-end, suggests the key narrative has shifted from interest-rates to recession.  

Throughout this hiking cycle, the bond market via the US2YR front ran the Fed on interest rate projections. The latest SEPs – summary of economic projections – increased the terminal rate to 5.1%. In response, the US2YR yield fell. For the first time since the 2020 COVID crash, the US2YR is below Fed Funds. In my view, this suggests the bond market no longer believes the Fed can keep rates as high as projected over the next two years. 

The US10YR yield, a proxy for inflation and growth sentiment, fell from ~4.3% to ~3.5%. On one hand, it suggests the bond market has grown more comfortable with inflation. On the other hand, it suggests the bond market has grown more concerned with growth. You do not lock up money for 10 years unless you believe inflation will below those levels and/or are concerned stocks will struggle to provide a competitive return. I think it is a little bit of both.

To summarize, the goal posts have shifted. Before this week, falling treasury yields were a tailwind for stocks. Now, falling treasury yields are a headwind. A retreating US2YR yield is no longer a signal of a more dovish Fed, but a warning that the Fed will need to cut rates to combat a recession of their own creation. A retreating US10YR yield is no longer a vote of confidence regarding inflation, but a warning that growth may slow more rapidly than anticipated. The bond market is telling us the Fed’s 5.1% terminal rate is less of a concern than the magnitude of the slowdown or recession ahead. Stocks are listening. 

The Week Ahead  

This week is much lighter than the prior as we approach the Christmas Holiday. Not much on Monday in the way of earnings or economic releases. 

On Tuesday, we’ll get SAAR building permits and housing starts. Ideally, these numbers come in above expectations. We want the price of housing to come down. That is accomplished by increasing supply. If more permits have been issued and houses start, then supply will grow. However, given interest rates and the state of the real estate market, I am not optimistic. 

On Thursday, alongside weekly jobless data, Paychex (PAYX) reports earnings. Paychex provides payroll services for small-to-medium size businesses. If they have a bad number, it implies the businesses they support may be in the process of right-sizing their workforces, which is bullish for labor data to come. 

On Friday, PCE, the Fed’s preferred inflation gauge, releases at 8:30AM before the bell. To avoid a Friday sell-off, we need Core to meet or beat the 4.6% consensus. Last month, Core was 5%; Headline was 6%. This could push the Fed toward a 25 bps hike in February instead of 50. If PCE comes in too hot, it will compound fears surrounding a recession caused by overtightening.

An Out-of-Consensus Take on 1H23

Currently, consensus is forming that new lows will be made in the 1H23 as the lagged effects of Fed policy finally catch up to earnings. However, this low will be the low as it will adequately reset earning expectations and valuation multiples. Concisely, we will go down to start the year before ending the year higher. 

My thesis is that earnings will hold up as long as the labor market does. I think that as long as people have jobs, people will continue normal spending habits to the best of their ability. Consequently, while I agree with the bears on the destination, I disagree on the timing. I do not foresee the job market meaningfully deteriorating in the 1H23 to affect 1Q23 earnings and guidance the way bears are forecasting. Therefore, if we trade lower into earnings season on the rationale earnings will finally collapse and payrolls show a resilient labor market, then we could be set up for a “better-than-feared” earnings season, catalyzing another bear market rally. 

Prices still have room to fall before we’re statistically oversold, but there has been a renewed level of bearishness that I do not think is appropriate. While last week was busy, I do not think we learned anything new or material to justify the bearish tilt. I feel markets are getting emotional, which means opportunities are forming.