January 3, 2023

The Federal Reserve (“Fed”) is continuing to tighten into slowing growth with higher rates and a shrinking balance sheet. The tightening campaign is not isolated to the United States. Central banks, excluding China, are tightening around the world. The Bank of Japan was the latest to start down the path of normalization and others such as the European Central Bank and the Bank of England are playing catch up, which should remove an anchor on US bond yields.

While the economy has remained resilient due to the strength of consumer balance sheets along with abundant job and wage growth, recession signals are mounting. Importantly, the market has never bottomed BEFORE entering a recession. The Fed now seems awfully close to projecting a recession itself. The Fed’s December “dot plot” showed higher inflation, slower growth, and an increase in unemployment in 2023 that has historically been consistent with recessions. While commodities, goods, and housing deflation is unfolding, the Fed is now primarily focused on cooling the labor market in order to combat robust wage growth underpinning services excluding housing inflation.

We are likely reaching the point where the direction of the stock market will be less about the Fed and more about the consequences of the Fed’s tightening campaign.  We expect more earnings downside ahead as the lagged effects of tighter monetary policy ripple through the economy and profit margins come under pressure. It is doubtful that the bear market has fully run its course.  We continue to patiently wait for further evidence of investor capitulation on the economic and earnings outlook for this coming year.  As economic and earnings recession forecasts become reality, it should catalyze a “cathartic” volatility spike and lead to a more compelling risk/return opportunity for stocks.