The Week Behind

Behind a bullish embrace of December Payrolls and Services ISM, the majors turned what was looking like a negative week into a positive one. Payrolls showed wage inflation had slowed. For the first time since the COVID-recession, Services ISM revealed contraction. Both suggest services inflation is coming under control. These perceived wins for the Fed are also wins for the “soft landing” bulls. The DOW and S&P 500 both added ~1.45%. The NASDAQ lagged but still added ~1%. The US2Y, US10Y, and USD all ended the week lower, which is supportive of the upward lift in equities. 

Highlights

• AAPL did not pre-announce a bad quarter.
• On Tuesday, inflation data in the EU surprised to the downside, catalyzing a rally in EU equities.
• Thursday, ADP employment and jobless claims showcased a strong labor market, which sent markets lower until St. Louis Fed Chief Bullard suggested rates were nearing sufficiently high levels.
• Friday, Payrolls and Services ISM provided evidence that services inflation is cooling, increasing the probability of a “soft landing”. 

The Counterfactual – December Payrolls

Despite showcasing a hotter-than-anticipated labor market, Payrolls was met with a bullish response courtesy of wage growth coming in below expectations: 4.6% YoY increase versus the 5% consensus. Let discuss the bullish interpretation:

The Fed is currently most concerned with wage inflation. It is the last inflationary factor to fold. Consequently, the Fed’s victory over wage inflation is the Fed’s victory over all inflation. The battle for wage-inflation is the war for all-inflation. 

Heading into Payrolls, bulls were hoping for an increase in unemployment. One antidote for wage inflation is higher unemployment. More people looking for work means less pressure on employers to offer raises to retain talent or offer above market rates to attract new talent. This slows wage inflation. However, this report saw wage growth slow without increasing unemployment: soft landing. While one data point does not make a trend and earnings will need to withstand the 425 bps of tightening already in the system, this report provides evidence a “soft landing” is still in the cards. 

Before moving forward, I think it worth entertaining a potential counterfactual. If stocks had declined on this report instead, I think the narrative would have attributed the sell-off to unemployment going down, green-lighting tighter Fed policy, which increases the odds of recession. That being said, price is truth. We did not sell-off. We rallied. For now, the interpretation behind slowing wage inflation takes precedence over the interpretation I just laid out. Yelling at the stock market is an exercise in futility. It is more constructive to figure out why prices are moving the way they are and determine if those moves are justified.

The Week Ahead

This coming week has a nice mix of earnings and eco-data to comb through. 

As per earnings, on Wednesday, homebuilder KB Home (KBH) reports. The Fed wants housing costs to continue moving lower. Ideally, KBH will provide evidence supporting exactly that. Otherwise, at the end of the week, earnings season begins in earnest with the banks. On Friday, Bank of America (BAC), Wells Fargo (WFC), JP Morgan (JPM), Citi (C), BlackRock (BLK), and others report. Their reports provide tea leaves concerning the strength of the businesses and consumers they service.  

As per the macro, Powell speaks Tuesday morning in Sweden at 9AM. It is possible headlines from his speech will affect the day’s action. The main event is December CPI. It releases at 8:30AM Thursday ahead of the open. Last month, headline printed 7.1%; core printed 6%. This month, 6.5% is projected for headline; 5.7% for core.

The focus will be on Core CPI. Given the weak ISM and slowing wages, there is reason to believe the core projection is achievable. If CPI comes in below consensus – giving the Fed additional reason to slow or pause – then we should see a nice rally. Of course, a red-hot CPI would be bearish, but given the recent flow of data, I do not place a high probability on that outcome.   

Yields and Equities

A few weeks ago, I wrote that the relation between yields and equities had reversed. For most of 2022, the relationship was inverse: yields up; equities down. It was that simple. For a week or two in December, it appeared as though that relationship had shifted because the retreat in yields was signaling recession as opposed to a more dovish Fed. However, in the last two weeks, that relationship has gone back to normal. A more reliable relation still exists between equities and the USD. Even when the relation between yields and equities reversed, the inverse relation between the USD and equities persisted. 

We should still monitor for a sharp decrease in treasury yields because I think it would be the bond market attempting to price in a recession. Depending on the velocity of the fall, equities might rally: lower yields – lower hurdle rates – makes stocks more attractive. However, once equities realize yields are falling because it means recession is coming, then equities would start trading down to price in the earnings risk associated with recession. This is an important dynamic to watch for. It could be a hint that equities are pricing in a more pronounced slowdown if they have not already.