A Shift In Emphasis

Despite a vast number of companies reporting before and after each session, economic data dominated this week’s tape (2/13 – 2/17/23). The market is shifting its emphasis from the micro – company-specific developments – to the macro – economy-wide developments. While this shift occurs quarterly, it is worth noting because in 2022 it provided bears an opportunity to reassert themselves without real evidence to support their case. The psychology works as such: 

U.S. companies are some of the best run in the world. Overall, they do not often disappoint. Even in a dreary economic backdrop, their earnings generate optimism. Once the light of earnings fades and all we have left is a murky macroeconomy besieged by the Federal Reserve and historic inflation, suddenly, we do not feel as constructive on stocks.    

Advantage Bears

Based on that psychology, bears tend to have the advantage in macro conversations; whereas, bulls have it in micro conversations. Consequently, as the emphasis shifts from the micro to the macro, bears have an opportunity to reassert themselves.   

Much of the early-year rally can be attributed to markets pricing-out Fed-risk – risk associated with the Fed causing a recession by hiking rates too much – a macro factor. Since the beginning of the year, inflation data built a case for the Fed to stop around 5%. With a known terminal rate, market’s sole focus became earnings-risk – determining how earnings will hold up against 2022’s 425 bps of Fed tightening –  a micro factor. In summary, over the last three months, the market has been more focused on the micro, where the bulls have the advantage, than the macro, where the bears have the advantage. 

However, recent economic data – January Payrolls, CPI, PPI, etc… –  have led Fed speakers and bearish analysts to advocate for a 6-7% terminal rate. Right now, consensus is 5%; 6-7% implies 100-200 bps are not yet priced-in. This reintroduces Fed-risk, a macro factor, as the primary concern in the market, which gives bears the advantage. The more hikes there are left, the worse the outlook for future earnings. 

The Next Risk To Markets

That said, the next big risk for markets comes via February Nonfarm Payrolls, which releases March 10th. For my synopsis on last month’s report, click here. 

Nonfarm payrolls is one of the most reliable economic reports. It carries a lot of weight in Fed policy. If February Payrolls confirms the economy is hotter-than-thought, January’s record strength was not an anomaly, or debunks the economic fiction of strong job creation without strong wage pressure, then we can expect markets to price-in more Fed rate hikes to accommodate a higher terminal rate. The higher the terminal rate, the lower stock valuations go. This is why “good news” on jobs has typically been considered “bad news” for stocks.

Risk Creates Opportunities 

Based on my economic thesis, a sell-off predicated on a strong labor market would create a tactical buying opportunity.

My economic thesis is that earnings will not capitulate until employment capitulates. The labor market is such that if you want a job, you can find one. It may not be in your field, but a job exists for the taking. As long as that remains the case, it is hard for me to get behind an earnings collapse. Consequently, if February Payrolls catalyzes a sell-off that prices-in Fed Funds above 5.25% and implies lower earnings, then I think 2nd quarter earnings will spark a better-than-feared rally: Earnings will be buoyed by a resilient consumer supported by a strong labor market coinciding with emphasis shifting back to the micro as is common with earnings season.