Since our last update, markets have experienced a significant bounce, rallying approximately 10% from the October lows. After months of surprisingly high inflation data, markets finally got an inflation surprise this month in the opposite direction, with both the consumer and producer price indexes coming in softer than expected. Given the widely oversold technical environment, this triggered a rally, particularly in high growth sectors where rising interest rates were most punishing on valuations and access to capital. The reason for the rally is the belief that evidence of lower inflation will prove to the Fed that their rate hikes are working, allowing them to eventually ‘pivot’ to a less restrictive stance where rate hikes slow or even stop.
However, markets have been lulled into this optimism twice before only to see its hopes dashed by disappointing data and a resolute Fed unwilling to bend at the first sign of a slowdown. Other economic indicators such as housing starts, manufacturing output, retail sales, and GDP have already been showning a slowdown for some time, with inflation remaining stubbornly high despite all this. Continued supply chain challenges and a historically tight labor market have prevented the economy from adjusting as quickly as in prior cycles, which is why the Fed has had to remain firm until they are certain inflation is coming down. With these latest data, markets are giving more credence to corroborating signs that both supply chain challenges and labor market imbalances are finally starting to clear, even as the Fed governors maintain their hawkish rhetoric.
On the supply chain, shipping rates have plummeted in recent months with inventories built up ahead of the holiday shopping season. Companies that got squeezed by being too light on inventory last year may have now overstocked, and inventory markdowns in recent earnings reports support the notion of less price pressures going forward. When you couple this with freight prices that are declining due to falling oil prices and weaker expected demand, then it seems plausible that this component to inflation may have peaked.
On the labor front, the pace of payroll gains has declined back to pre-pandemic levels, and while job openings have remained elevated, layoffs have increased in recent weeks. While these layoffs are thus far concentrated on Wall Street and Silicon Valley, it is likely this will spread more broadly across the economy as companies look to cut costs ahead of a recession. This is contributing to a moderation in wage gains, a major feeder into inflation. While the Fed wants to see strong labor fundamentals, labor demand has simply been too strong relative to the economy’s supply curve in the last two years. So a more balanced labor market will be gladly welcomed.
Collectively, it seems that the Fed is slowly achieving their objective, even if is taking longer than expected and with more likelihood of a recession, as shown by an inverted yield curve. While a ‘Fed pivot’ would remove a major cloud hanging over the market on the rates side, markets will still have to grapple with the other major component to valuations – earnings. Throughout the year corporate earnings have weakened, with most executives cutting their guidance from the rosy outlooks they had last year. But as we’ve seen in prior quarters, earnings have proven to be quite resilient, with companies broadly able to protect their profits and beat expectations, albeit at a declining rate. Consumers are also continuing to spend even as they trade down, cut discretionary purchases, and take on more debt. The question going forward will be whether the imminent recession is a mild one – with earnings muddling through and consumers hanging in – or a deeper one where a material decline in earnings and consumer spending power weigh further on equity valuations.
So it remains to be seen if the market is again getting ahead of itself this time, or we have in fact bottomed. The verdict is also out on how “hard” or “soft” the Fed’s landing will be. Nevertheless, stocks are forward-looking indicators and tend to recover well in advance of the economy itself. As a result, forward returns a year or two out from such bear-market declines have generally been pretty good, statistically speaking. For these reasons, we remain cautiously optimistic looking forward and believe now is a good time to stay the course and find opportunities to add value in portfolios. We’ve already added a few high-quality names this year that previously were out of our reach, and we’ll continue to be on the lookout for more.
You can be confident that we will continue to monitor these developments very closely. We welcome your questions and comments and wish you and your families well.