Dr. Jekyll and Mr. Market

Bottom Line

It’s been a “Jekyll & Hyde” market over the past several months, with equity and fixed-income investors pointing in different, almost opposite, directions. To be sure, inflation clearly peaked across the board last year and is receding. The question is how quickly. Bond investors believe it will grind lower over an extended time. In stark contrast, the equity market is whistling past the graveyard with a more optimistic, “Immaculate Disinflation,” view that inflation will fall much faster.

• Consumer Price Index (CPI) Nominal retail CPI inflation spiked from 1.4% year-over-year (y/y) in January 2021 to a 41-year high of 9.1% in June 2022, but has since fallen to 6.4% in January. The core CPI (which excludes food and energy prices) declined from a 40-year high of 6.6% last September to 5.6% in January. 
• Personal Consumption Expenditures (PCE) Index Nominal PCE hit a 41-year high of 7% y/y in June 2022 but slowed to 5.4% in January. Core PCE (the Fed’s preferred measure of inflation) peaked at a 39-year high of 5.3% y/y in March 2022 but eased to 4.7% in January. 

The equity market is genuflecting before the altar of the “Immaculate Pivot,” the belief the Fed will not only stop hiking interest rates soon, but cut them. The bond market, meanwhile, thinks the Fed’s will be more patient and data-dependent as it seek its 2% target. 

We’re expecting another rate hike While the Fed downshifted in its last two policy-setting meetings—a half-point hike in December and a quarter-point bump last month—we think it is not done combating longer-term inflationary pressures and expectations. We’re now expecting three more quarter-point fed funds hikes in March, May and June. That would take the target range to 5.25%-5.5%, at which point we believe the Fed will pause into 2024.

Phillips Curve trade-off If the Fed remains hawkish in coming months, the unemployment rate (now sitting at a 53-year low at 3.4%) could rise to the Fed’s target of 4.6%, perhaps later this year. Clearly, the Fed is willing to pay the price of weaker economic growth and higher unemployment to achieve its objective of slower, trendline inflation. To that point, Leading Economic Indicators (LEI) have declined 10 months in a row, dragging the index to a 2-year low. With a 2/10 yield-curve inversion of around 80-basis points, there’s an elevated risk of a rocky landing or recession over the next year. 

Whither consumer spending? Consumers are still spending, with retail sales rising in January by a robust 3% month-over-month, its largest such gain in nearly two years. Consensus is this is due to a still-strong labor market, but signs have emerged it is weaker than it looks. Case in point is the blowout January jobs report was misleading due to the Labor Department’s seasonal adjustment. It may be revised down significantly, especially as other measures of employment, such as Challenger job cuts and the ADP National Employment Report, have softened. Also, some of that spending strength might be related to the 8.7% increase in Social Security checks in January (the largest annual inflation adjustment in decades) dispersed to roughly 70 million recipients. But surprisingly, consumer confidence plunged to a 3-month low of 102.9 in February and the personal savings rate has risen from a 17-year low of 2.7% last June to 4.7% in January. With inflation still rampant, all of this suggests consumer purchases could slow meaningfully in February and beyond. 

Manufacturing contraction The ISM manufacturing index has plummeted from a 38-year high of 63.7 in March 2021 to a nearly 3-year low of 47.7 in February 2023. This metric has been below the critical 50 level in each of the past four months. In addition, all six of the regional Fed manufacturing indexes have slipped to 2-year lows over the past 18 months. 

Housing recession As mortgage rates have more than doubled, from 3% to 7.35%, over the past year, the Case-Shiller Home Price Index has plummeted from a peak of 90 in November 2020 to a two-and-a-half year low of 31 in December 2022. Pending home sales have fallen in 19 of the past 20 months, and existing home sales (which account for 86% of the total housing market) have declined for 12 consecutive months through January to a 12-year low, with unit sales down 38%. 

Punk earnings season We’re 95% done with the fourth-quarter reporting season. Revenues rose about 6% y/y in the fourth quarter, largely due to inflation. By comparison, in the fourth quarter of 2021, they rose 16% y/y. Earnings declined in the fourth quarter of 2022 by -4.5% y/y, because of elevated inflation, rising interest rates and slimmer profit margins. The shrink in margins was due to higher labor, commodity, transportation and warehousing costs. In stark contrast, earnings in the fourth quarter of 2021 rose nearly 31% y/y. This is the first y/y decline in profits since the third quarter of 2020. Profit margins declined at an accelerating pace of about -10% in the fourth quarter, the fourth consecutive decline. 

Importantly, most companies provided downward guidance for full-year 2023 earnings. Last October, we cut our outlook for S&P 500 earnings forecast from $230 to $200 in 2023, versus $209 in 2021 and $220 in 2022. Consensus earnings for 2023 have declined from $250 to $225, which suggests more downside risk in coming months. 

Choppy financial market performance From its oversold trough in mid-October at 3,492 to an overbought peak of 4,195 on Feb. 2, the S&P enjoyed a powerful midterm election rally of more than 20%. Since that point, equity investors have shifted their focus back to challenging fundamentals, and stocks have corrected by more than 6% over the past month. We believe stocks could retest their October trough in coming months, as investors reduce their earnings estimates. Over this same period, benchmark 10-year Treasury yields fell from 4.25% last October to 3.4% in early February, but surged to more than 4% over the past month. 

Adjusting our GDP and inflation estimates The liquidity, equity and fixed-income investment professionals who comprise Federated Hermes’s macroeconomic policy committee met Wednesday to discuss the impact of Fed monetary policy on the economy.

• The Commerce Department revised fourth quarter 2022 GDP growth down from 2.9% to 2.7%, versus 3.2% in the third quarter. There was no change in full-year growth of 2.1% in 2022, compared with 5.9% in 2021. 
• On the basis of the Fed’s rate downshift, robust consumer spending and other metrics, we increased our first quarter 2023 growth estimate from 0.5% to 1.1%. The Blue Chip consensus raised its from -0.5% to -0.1% (within a range of -1.5% to 1.2%).
• We’re expecting relatively strong “Mapril” spending due to a still-healthy labor market, so we raised our second quarter 2023 forecast from -0.3% to 0.3%. The Blue Chip consensus raised its from -0.9% to -0.5% (within a range of -2.3% to 1.2%).
• We increased our third quarter 2023 estimate from -1.2% to -0.5%. The Blue Chip consensus lowered its from 0.0% to -0.1% (within a range of -2.3% to 1.8%).
• We bumped up our fourth quarter of 2023 projection from -0.9% to -0.7%. The Blue Chip consensus lowered its from 0.9% to 0.6% (within a range of -1.3% to 2.3%).
• As a result of those adjustments, we raised our full-year 2023 GDP growth estimate from 0.6% to 1.1%. The Blue Chip consensus raised its from 0.5% to 0.7% (within a range of 0.1% to 1.5%).
• We initiated a full-year 2024 GDP estimate of 1.1%. The Blue Chip consensus did not alter theirs at 1.2% (within a range of 0.3% to 2%).
• Inflation projections: we initiated a full-year 2024 forecast for core CPI at 2.8% and core PCE inflation at 2.5%. We increased our full-year 2023 core CPI estimate from 3.7% to 3.9%, compared with 5.7% at the end of 2022 (down from a 40-year high of 6.6% in September 2022). We also increased our full-year 2023 forecast for core PCE inflation from 3.3% to 3.5%, compared with 4.6% at the end of 2022 (down from a 39-year high of 5.3% in March 2022).