Inflation – Finally Fading?
Inflation has been much stickier than anyone anticipated, but we have seen signs of a downward trend forming. Will this continue? With supply chains normalizing, the biggest question mark is when the falling real estate prices and stabilizing rent costs will begin to show up in the CPI print. We believe this will come to fruition mid-year, leading to a more pronounced reduction in overall inflation by the second half of the year.
Fed Rate Hikes – Stay Aggressive or Take the Foot Off the Gas Pedal?
The Fed has been much more hawkish indicating that they are going to remain aggressive in their stance to fight inflation by raising rates. They just decreased the extent of their rate hikes down to 50 basis points, but how much longer will these continue? And, have they gone too far without letting the impacts of their prior rate hikes play out? We see two possible scenarios for market reactions depending on what happens: (1) Fed continues hiking 25-50 basis points for the first half of 2022, leading to persistent downside volatility and a more likely recession in the second half of the year, or (2) Fed signals a slowdown and begins reducing (and eventually stopping) rate hikes in Q1/Q2, leading to a market rally and eventual economic turnaround by end of 2023/early 2024.
Slowing Growth – GDP and Earnings.
The Conference Board is forecasting that 2022 Real GDP will come in close to 2%, and they are forecasting zero growth for 2023. The International Monetary Fund (IMF) is forecasting growth of just 1.0% for US GDP this year. On the earnings side, we are likely to a decline for 2022 once all Q4 numbers are released, and many large corporations are signaling layoffs and/or issuing negative guidance for this year. This is not a forgone conclusion, especially as most major companies reported better-than-expected earnings and shown resiliency last year. This bares watching and will be impacted by potential Fed actions and consumer behavior.
Speaking of the consumer, Americans have remained resilient with their spending habits even with high inflation. We also saw wage growth and an increase in disposable income last year. With that being said, we started to see “cracks” at the end of last year with retail sales declining more than expected. The consumer will need to stay strong if we want to stave off a potential recession. As long as inflation continues to subside and the labor market stays fairly strong, we expect to see continued resiliency to this year (albeit more modest than 2022).
Housing Should Continue to Lose Its “Sizzle”.
The impact of the Fed rate hikes on real estate was most immediately felt in the form of higher mortgage and loan rates. However, we began to see sizeable drops off ins home sales and prices in the second half of last year as higher rates scared off buyers. We expect to see that continue into early 2023, especially if the Fed continues hiking rates. We also believe that rent costs, which has been the “stickiest” component of shelter inflation, will continue to plateau and be reflected in the CPI print figures by mid-2023. Shelter costs coming down is critical to CPI/inflation falling overall.
Job Market Strength.Less Job Openings and Higher Unemployment Equals Lower Inflation
Jobless claims have begun to return to pre-pandemic levels amid a tight labor market, and unemployment has stayed low at 3.5%. Job growth has also remained strong and wages have climbed. However, with many employers signaling layoffs and showing concerns about a coming recession, it is likely that job growth and payrolls won’t be as robust as 2022. Furthermore, job openings (as measured by the Bureau of Labor Statistics’ JOLTS survey) are down over 7% since last year. Less jobs and potentially higher unemployment should lead to lower wages, which should help reduce inflation as a result.
The Value vs. Growth Dichotomy.
Value far surpassed Growth last year on a relative basis, led mainly by Energy, Utilities, and Consumer Staples sectors. Growth stocks, namely Tech stocks, struggled significantly as rates rose and inflation soared. Growth stock valuations were already inflated pre-pandemic, and the big post-COVID rally didn’t help. While we don’t expect the same level of drawdown in Growth this year, these stocks should continue to be pressured until we see brighter economic prospects on the horizon. We do expect Value stocks to remain attractive given economic uncertainty and inflation likely to stay elevated. However, we don’t expect to see the same level of relative outperformance like we did in 2022, especially if inflation continues to cool and the Fed reduces (and eventually stops) their rate hikes. Of course, if a recession does come to pass later this year, we would expect Value to outperform Growth in the near term, followed by a Growth rebound once an eventual economic turnaround takes shape.
International Stocks – Will the Rally Continue?
We saw a soaring dollar in the first nine months of 2022, and then it weakened by over 5% in Q4. As a result of the currency effect, Developed International returns flew past US equity and ended the year with outperformance of nearly 3.5%. International stocks continue to be attractively valued compared to their US counterparts, and many believe International stocks are technically “due” to outperform after years and years of US dominance. However, we believe that more headwinds exist overseas compared to US markets, particularly with the continued Ukraine-Russia war and a higher inflation rate (over 9%). As a result, we believe International will underperform US markets this year.
Attractive Bond & Cash Equivalent Yields.
After years of a low-rate environment, we finally saw a revival of higher bond yields last year, led by Fed rate hikes. Most investment-grade bonds, particularly with short to intermediate maturities, are paying north of 4%. Even many cash equivalents, such as money market funds, are paying over 3%. Investors are now being rewarded with an attractive income stream, and we see this continuing as the Fed is expected to continue raising rates at least through Q1. As the Fed eventually winds down their rate hike cycle, we also expect a surge of more investors piling into bonds to secure these higher rates while available.
Will We See a Recession or “Soft-Landing”?
We believe that the answer to this question is in the hands of the Fed. Will they or won’t they slow rate hikes enough to avoid pushing the economy over the edge? The consumer and job market, and even corporate earnings, have remained very resilient in the face of high inflation. Given this resiliency, we believe that a soft-landing is still possible if they can begin to slow and eventually stop hiking by end of Q1.