January 17, 2023

The stock market has gotten off to a solid start this year, no doubt encouraged by the Goldilocks set of economic data releases the past two weeks showing resilient growth and cooling inflation, which is emboldening the “this time is different” soft landing calls.  Although we anticipate another downshift to a +25 basis point increase in interest rates starting with the February FOMC meeting, it is unlikely that the Federal Reserve (“Fed”) diverts from its current path of tighter for longer.  Going forward, we believe the Fed reaction function will be dictated by three factors: (1) continued progress on moderating inflation; (2) evidence that the labor market is in fact cooling and that wage growth is slowing; and (3) avoidance of a premature easing in financial conditions.

The U.S. economy has remained resilient thanks to the strength of consumer balance sheets, along with abundant job and wage growth; however, recession signals are mounting.  Deflation in commodities, goods, and housing is unfolding, but the Fed is now primarily focused on cooling the labor market in order to cool robust wage growth that underpins core services excluding housing inflation.  Investor attention, however, will now turn to earnings as we enter what is likely to be a consequential earnings season.  We expect to see more evidence of margin pressures, especially as pricing power weakens while labor costs remain elevated and sticky.  We also expect more conservative initial outlooks for 2023 as CEOs anticipate more difficult economic conditions ahead, which should result in downward earnings revisions.

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 calendar 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.