The Santa Claus rally worked again this season, producing above-average returns. However, data releases continue to put pressure on relief rallies this week, now that traders are coming back to the office. Fed Minutes, which detail what the Fed discussed in December, pointed to increased concerns that they are losing their messaging power. With stocks posting solid gains in October and November, Fed officials openly voiced displeasure over easing monetary conditions.
If there is any doubt, one can always rely on their Wall Street Journal mouthpiece, Nick Timiraos. His latest article opened with this: “Federal Reserve officials offered uncharacteristically blunt words of warning to investors that cautioned against underestimating the central bank’s determination to hold interest rates at higher levels to bring down inflation.” As we have been noting for months now, this should NOT be new news. The Fed is clearly going to overstay their welcome, if they have not already. A huge mistake during the 70’s was easing conditions too soon, via increasing money supply, and allowing inflation to come back to the fore until Volker forced a deep recession. This Fed is laser focused on not letting that happen again. They want to beat inflation immediately and not have another Lost Decade. No participants expect a rate cut in 2023. They will err on the side of inflationary pessimism after being too loose, and wrong, for years.
With that being said, ADP’s employment report showed much stronger job growth in December than expected. Slowing wage gains is goal #1 for this Fed in their quest to bring inflation back towards 2%. Signs like this mean the Fed’s projection of higher rates for longer leading to a rise in unemployment (which always precedes a recession) will come to fruition. Hence, stocks gave back all of the Santa Claus rally yesterday after the report. Today’s Bureau of Labor Statistics employment report carries huge implications. Again, good news is bad now. A continued strong rise in employment and further wage gains will be met with aggressive selling of stocks. In this perverse world, we want jobs to become scarce and income levels to slow their ascent.
Winners Become Losers and Vice Versa:
Another sign that the calendar flipped (aside from remembering to write 2023) is the relief rally occurring in the most beaten down areas and vice versa. Prior to yesterday’s drawdown, 19 of the 20 worst performing stocks for 2022 were positive to start the year. The only one that keeps losing is Tesla, which is down another 11% this year. Intel#, Expedia#, Netflix#, Peloton, Paramount, Warner Brothers, Hanes Brands and Mohawk Industries (world’s largest flooring company) are all up 5%+ in 2023 but were down over 40% last year. On the flip side, numerous oil, pharmaceutical and consumer staples winners from last year are down 5%+ as profit taking arrives.
This is a short-term phenomenon. We would not read too much into a few trading days of activity, especially following such a disastrous year for stocks. As noted last week, the January Effect is real. Investors were quick to sell losers for tax purposes and portfolio dressing in December. That relief rally is upon us but does not change the economic landscape. Rather, it could give investors an opportune time to exit stocks which will have a tougher time going forward in a world with higher interest rates, tight liquidity, a slowing consumer and full valuations. Not all bounces are created equal. There are sure to be new leaders emerging as the Fed nears an end to this tightening phase. Deciphering between the two will be the key to success in 2023.
No More Negative Yielding Debt:
In another sign that we are entering a new era for interest rates, the amount of negative yielding debt is finally back to zero for the first time since 2010. Japanese bonds were the last holdout as their Central Bank unexpectedly made a policy shift late last year, allowing yields to rise. Holders of the nearly $20 trillion of global negative rate debt from early 2020 are licking their wounds today. Things still are not great in Japan though, as 2-year government bonds only yield a whopping 0.03%!
However, debt of other developed nations and high-quality corporate debt are back in the 4% – 6% range, offering a very competitive option to stocks. Normalcy here is a good thing for savers.
Another way to look at this is via dividend yields relative to Treasury rates. Throughout history, bonds normally paid a higher rate of return than holding stocks to collect dividends. After an attempt on Modern Monetary Theory, government handouts and zero % interest rates, it is becoming quite clear that “normalcy” is coming back. During this period of 0% interest rates, nearly 90% of stocks had a dividend yield greater than the 10-year Treasury. Today, that number is back below 25% and at its lowest level since 2012:
Recession Coming or Already Here?
Much of the success for investors in 2023 will depend on if/when and how strong a recession will be. Numerous leading indicators are pointing to tight monetary policy, forcing the U.S. and much of the developed world into a recession soon. As is often discussed, the most powerful indicator is an inverted yield curve, which is prevalent today. Further Fed Fund increases, like the one in February, will only add to this inversion. Consumers and corporations alike are seeing tighter lending standards and much higher interest payments, both of which will crimp growth in the coming months.
Another key indicator stems from a St. Louis Federal Reserve Bank’s analysis that looks at each state’s economic activity. In simple terms, when more than half of the U.S. States have falling activity within their borders, it offers “reasonable confidence” that the nation will fall into a recession shortly thereafter. Right now, the Philadelphia Fed data tracker shows 27 states in decline during the 4th quarter. As you can see below, this indicator has a 6 for 6 track record dating back to 1980. The only question is how strong a recession will be, which directly correlates to how long this Fed will want to keep pressing down on growth.
Mr. Bean, Rowan Atkinson, turns 68 today. Eddie Redmayne is 41. SNL Alum, Kate McKinnon, is 39 today.
James Vogt, 610-260-2214