Welcome to 2023. Yesterday’s market seemed a bit different than late December. Futures early on suggested a strong start, but that faded quickly. Soon markets were down almost a full percentage point. That certainly didn’t feel very different from last week! But over the course of the rest of the day, persistent selling disappeared, except for the energy sector. So many analysts and economists predicted a bad start to 2023 that a lousy start seemed inevitable. On Wall Street, when everyone agrees, markets often fool us.
The consensus is that a recession is coming in 2023, a culmination of all the central bank moves made in 2022. Exactly when it begins is open to debate. So is the severity. There are some still opining that a soft landing is possible, but every day, the facts speak deceleration. Christmas sales were OK but not great. Apple# followers suggest the company has slowed its orders for early 2023, while backlogs for its high-end phones are disappearing. Tesla reported Q4 sales that were outright disappointing. We will hear from other auto makers this week. Manhattan apartment sales in the fourth quarter were the lowest since pre-pandemic.
But how much of this is new news? The data may be new, but we all knew the economy was slowing. The economy needs to slow to get inflation to moderate. The key piece of economic data this week will be Friday’s employment report. In a steady state slow growth economy, normally about 50,000 new jobs should be created each month. The last report, for November, showed an increase of 263,000 jobs. During no month of 2022 did job growth fall below 200,000. Companies remain reluctant to lay off skilled workers given past difficulties of hiring to fill critical needs. But when sales actually fall, they will change their minds. Did that process begin in December? We will learn more on Friday. A very weak number would elicit two reactions. On the one hand, a poor number will suggest that the Fed doesn’t have to increase interest rates much further. Or at a minimum, the pace of future increases might slow. Stocks would react positively to this train of thought. On the other hand, bad economic news is bad economic news. Falling sales. Reduced pricing power. Lower profits. The common thread one hears daily is that earnings estimates for 2023 are too high. While analysts may not know this, the market does. What the market knows is already discounted in equity prices.
Not to be repetitive, but stock prices are a function of interest rates (reflected through the P/E ratio) and earnings. Over the past couple of trading sessions the short-term surge in 10-year bond yields has stopped. At least for now, a revisit of rates above 4% for longer- term Treasuries appears unlikely. Slower growth and less inflation should set a pattern of lower rates, not higher ones. Simply said, unless there is a totally unexpected surge in inflation over the next few months, which no one expects, interest rates should not weigh on stock prices in 2023. If anything, they could become a modest tailwind. 2023 is all about earnings, not just for this year, but next year as well. That depends on the extent of the pending slowdown. When does it begin and how long does it last?
Which brings us back to the Fed. If you look through the entire 21st century, all two decades plus, the market’s behavior has been closely aligned to the Fed. The first decade began with a mild recession and easy money. The Fed subsequently stayed with easy money too long, created a housing bubble that ultimately burst mid-decade, leading to the Great Recession and massive foreclosures. The Fed responded by moving the Fed Funds rate to near zero and didn’t make its first move up until the end of 2015. It created yet another bubble that came to an end last year amid the worst inflation since the 1970s. Now we live in the aftermath of tight money and a slowing economy.
How long will tight money be needed to normalize the economy? Maybe a better question is when will the Fed try to normalize policy, step back, and let the economy do its own thing, if ever? This Friday’s employment report is the last one before the next FOMC meeting that concludes February 1. There will be one more CPI report. There won’t be enough data to suggest a sustained change in trend. We do know that inflation and job growth are both moderating. That alone is likely to mean the next rate increase is just 25 basis points.
Beyond that is a coin flip. Yes, I know the Fed had projected future rates via its dot plots into 2024. But the dot plots, historically, have been less accurate than throwing darts. All they do is project the mood of the day. The second FOMC meeting in 2023 ends March 16, 2 ½ months away. Predicting the economy and inflation 2 ½ months from now is like predicting the weather that far out. The weather will be warmer, the economy will be weaker, and inflation will be lower. Those are high probability outcomes. The details, however, are nothing more than a complete guess today. If data says we are in or at the cusp of recession and February sees little or no job growth, the Fed could do nothing in March. If inflation is still well over 4% and over 100,000 new jobs are being created each month, the Fed could move rates up one more time.
For the markets and the Fed, there are two critical moments ahead. The first is when it raises the Fed Funds rate for the last time. It’s actually possible that has already happened, but unlikely. It will take really miserable data between now and February 1 for that to happen. If the Fed doesn’t raise rates in March, that could be a signal, but only if the Fed suggests the possibility that its rate hiking cycle is over. Bottom line is we don’t know. The precise timing is a guess filled with a lot of uncertainty. But it is likely to happen during the first half of this year, perhaps in the first quarter.
The second critical moment is when the Fed sees inflationary pressures receding enough that it can ease its foot off the brake. That could come in two ways; a slowdown in the pace of balance sheet reduction, or an actual cut in the Fed Funds rates. Again, that depends on economic data we haven’t seen yet. What we do see, however, is that current policy, even without any more rate increases, is restrictive. Without any further increases, soon the Fed Funds rate will be higher than inflation. If one factors in the impact of balance sheet reduction, one can argue that the effective impact is close to a Fed Funds rate of 6%. Money supply is in decline. For now, that’s OK as Americans use up excessive savings built up during the pandemic. However, this is unsustainable without a serious recession. Thus, it is inevitable that the Fed, at some point, has to cut rates. When? When it sees data suggesting that inflation is in “permanent” decline. It won’t wait for it to get to its 2% target, but it will start to cut when the path to 2% is clear. It will likely start slowly. That’s fine with me and should be fine with most investors.
The termination of rate hikes and the start of rate decreases, are likely to be celebrated by equity investors. While a recession may not begin until well into 2023, if it begins at all, Fed interest rate moves will happen first. They could signal the end of a recession before one even begins, if it is brief enough.
Does that mean that the conventional wisdom of a bumpy stock market ride early in 2023 is wrong? Probably not. There are still too many uncertainties ahead. Inflation is still too high and the economy is still too strong. Fourth quarter earnings announcements may help. Corporate managements are at the front lines and can read the next few months at least as well as Fed officials.
Here are the conclusions:
1. 10-year yields, those most influential to P/E ratios, have peaked. P/E ratios have normalized for the vast majority of companies. The exception remains some of the high P/E favorites of the tech bubble still leaking air.
2. The Fed is close to the end of its rate hiking cycle. It may raise rates another 25 or 50 basis points before it is done, but is far less than the 4.5% cumulative move in 2022.
3. The economy and inflation are both decelerating. Services and wage inflation are likely to be more persistent than commodity and goods inflation, suggesting any Fed Funds rate cut is still months away.
4. Stock prices adjust to changes in earnings forecasts well before they happen. Look at the homebuilders. When their stocks peaked in early 2022, buyers were waiting in lines to attend open houses. Now with sales volumes near 2008 lows, their stocks are well off their lows. Never forget that stock prices are forward looking.
Over the next couple of months, expect volatility. Simply said, everyone’s short-term crystal ball is simply too cloudy to suggest otherwise. But as it becomes clear that pricing pressures are receding and that economic slack is upon us, stocks will look beyond the storm. With that said, this isn’t a time to be bold. The euphoria of 2021 continues to be obliterated. There could be one last flush that challenges or even pushes through the October lows, but that isn’t a certainty. What is likely, however, is that buyers will be cautious at first. To be sure, there will be some sifting through the graveyard trying to find some sign of life in speculative names obliterated in 2022, but that isn’t where leadership in 2023 will come from. 2023 will be different than 2022 or 2021. There will be a cost to borrow. Dividends will be important once again, as will the ability to sustain free cash flow growth. There will be massive amounts of government money spent on infrastructure. Health care will continue to advance. Stocks aren’t cheap overall. A final flush could change that, but even if that doesn’t happen, the value of great companies will rise as they continue to grow. This is a time of concern, but it isn’t a time for pessimism. That was last year’s story. The sick patient has been given his medicine. The impact takes some time, but it will work. Be patient and be positive.
Today, author Doris Kearns Goodwin is 80.
James M. Meyer, CFA 610-260-2220