February 13, 2023

The stock market rally to start this year has been a function of defensive positioning entering 2023, “Goldilocks” data that boosted investors’ soft landing hopes, and a favorable November thru April seasonal trading period amplified by the third year of a Presidential Cycle (a historically strong year for the market).

Contrary to the soft landing hopes that might encourage the Federal Reserve (“Fed”) to soon pause its rate hike campaign, more recent economic data suggests that both growth and inflation may be reaccelerating here in the first quarter.  First, we received a trifecta of strong employment data: (1) Job Openings and Labor Turnover Survey (JOLTS) is back up to 11 million, (2) initial unemployment claims are back below 200k, and (3) nonfarm payrolls came in much stronger than expected with a +513k jobs gain in January (along with a significant upward revisions to prior readings).  Second, January consumer spending also appears to have rebounded from soft November and December levels, confirmed by Visa and PayPal volumes, Bank of America’s own credit card data, and EvercoreISI Retailers’ Survey.  Third, reflecting this pick-up in growth, the Atlanta Federal Reserve’s Q1 GDPNow estimate has been revised up from +0.7% to +2.2%.

On the inflation side, upward revisions to the Bureau of Labor Statistics’ Consumer Price Index (CPI) last week indicated inflation readings in the second half of last year were actually higher than previously reported.  The latest Employment Cost Index for last year’s fourth quarter, along with January’s average hourly earnings and the Atlanta Federal Reserve’s Wage Tracker, suggest that wages, while moderating from last year’s highs, may now be plateauing at a level that would be inconsistent with the Fed’s 2% inflation target.  Lastly, the Cleveland Federal Reserve’s inflation NowCast points to the possibility of a near-term inflation scare with January and February CPI estimates that are tracking above consensus expectations and a significant reacceleration from November and December.

Meanwhile, fourth quarter earnings season has been one of the worst outside of a recession in the past 25 years with actual earnings disappointing relative to estimates that had already been revised down more than usual coming into the reporting period.  With roughly 80% of the S&P 500’s market cap having reported, earnings look to be down around 2% year over year for the December quarter, marking the first decline since the pandemic-impacted September quarter of 2020.  Forward EPS estimates also continue to get revised lower, primarily on weaker profit margins, suggesting we are likely now entering an earnings recession.

With stock valuations now higher, earnings per share estimates lower, investor sentiment more bullish, and market volatility lower (as measured by the VIX, the Cboe Volatility Index), the market may be set up for disappointment, especially if faster growth and higher inflation means that Federal Reserve Chairman Jay Powell is correct that the Fed must take rates higher for longer than the market is discounting.