The traditional “Santa Claus” rally was notably absent at year end, as stocks ended 2022 on a muted note. Investor concerns have shifted from fear of inflation and higher interest rates to fear of recession. Indeed, it seems to be the consensus of Wall Street pundits that a recession will begin sometime in the first half of 2023, followed by a recovery in the second half. Under this scenario it would follow that the Fed would “pivot” sooner rather than later from interest rate hikes toward cuts, which would fuel a new bull market.
We are somewhat skeptical about this consensus, if not in its conclusion but at least in its timing. First, if we have learned anything about investing, it is to be wary of a widely held consensus view. Warren Buffett once remarked that “you pay a high price for a cheery consensus.”, and we doubt that has changed. But we also believe that there are some inconvenient economic facts that suggest the Fed will be raising interest rates “higher for longer.” The most important such fact is the tightness of the labor market, as demonstrated by the following chart:
As of November 30, 2022, there were 1.7 job openings for every unemployed person, (or 0.6 unemployed persons per job opening), and an unemployment rate of 3.7%. As the chart demonstrates, U.S. companies enjoyed a long period during which the number of unemployed persons per job opening ranged from over 6 at the end of 2009 to about 1 in 2019, right before the pandemic-induced recession briefly spiked that back to 5. But after the sharp and brief recession in the spring of 2020, that number plummeted to 0.6. What does this mean for the Fed’s efforts to tame inflation? It probably means that the Fed will have to work harder and longer to reach its 2% inflation target. Roughly 70% of U.S. GDP is consumption driven, and consumption is driven by the number of employed people and their rate of compensation. With wage growth year-over-year in November of 2022 at 6.2%, and the number of people employed at a record 158.3 million, it appears that the labor market has not meaningfully cooled, even though the rate of compensation increases has decelerated somewhat from earlier in 2022.
We see other factors that indicate a longer slog for the Fed to cool inflation. Joe Carson, a former chief economist at Alliance Bernstein, proposed on his blog that the yield curve inversion which normally presages a recession may be flashing a “false positive”, at least for now. He cites the 11.8% growth (year-over-year through November, shown in the chart below) of bank credit to business, real estate, and consumers, which is the fastest annual growth since 2007. Usually, bank lending drops sharply before the economy enters a recession. Carson concludes that the restrictive credit conditions that precede a recession are not yet present.
More bullish investors might conclude that stronger labor markets and robust credit growth should result in better earnings growth and higher stock prices, at least for as long as they persist in the new year. Unfortunately, we doubt that such a positive result is very likely. First, we see higher labor costs and interest rates contracting profit margins at most companies. But more importantly, we see “higher for longer” interest rates needed to cool the economy impacting stock prices, and particularly prices of longer duration growth and technology stocks. Perhaps the Fed’s policies will produce a “soft landing” for the economy later in the year, but in the past that has proven to be an elusive goal.
What does all this mean for the year ahead? We conclude with Paul DeSisto’s closing remarks in his market commentary of Dec 30,2022:
Until we witness some solid indications of improvements in the inflation outlook and moderating of interest rate increases (the central bank’s “pivot”), cautious investing will be in order. That means cash and money market funds, government, agency and investment grade corporate debt, and stocks of companies that sell the necessities of life and have safe dividends. But the market will eventually return to bullish ways, and when it does it will be with a vengeance. Having funds in highly liquid cash and short-term investments will empower investors to reenter the ring when that happens.
Wishing you a healthy and prosperous New Year!!!