January 30, 2023

The market has gotten off to an impressive start in January with a “risk on” rally led mostly by smaller caps and more economically sensitive stocks, along with many of last year’s worst performers.  Investors have been emboldened by cooling inflation data and a resilient job market, bolstering hopes for a more dovish Fed and an economic soft landing.

While recession signals continue to mount, the most reliable concurrent indicator, initial jobless claims, continues to suggest “not yet.”  Entering this week’s Federal Open Market Committee (FOMC) meeting, evidence of slowing inflation is unmistakable, but it still seems premature for the Federal Reserve (“Fed”) to declare “Mission Accomplished.”  The three drivers of the Fed’s reaction function in our view remain: (1) continued progress on moderating inflation back towards its 2% target; (2) evidence that the labor market is in fact cooling and wage growth is slowing; and (3) avoidance of a premature easing of financial conditions.  A case can certainly be made for the first, but unfortunately, the labor market remains historically tight and financial conditions have continued to ease, raising doubt about the sustainability of progress towards the target.

Thus, while the Fed likely downshifts again to a +25 bps rate hike this week, we expect the language/guidance from Fed Chairman Jay Powell to remain hawkish (i.e. tighter for longer) to counter easing financial conditions. With deflation in commodities, goods, and housing unfolding, the Fed is now singularly focused on the stickiest element of the inflation picture – wage growth; therefore this week’s Employment Cost Index (ECI) release will be closely watched and analyzed.

We are now roughly one-third through the earnings season. The volume and magnitude of the earnings beats has been less than usual, and cautious outlooks are driving downward estimate revisions as we anticipated.  Stock reactions, however, have been unusual and confounding as misses have generally been rewarded and beats have gotten punished.  We remain doubtful that this bear market has fully run its course and await further evidence of investor capitulation on the economic and earnings outlook for the year ahead.