The price performance of the equity market during the first few days of the new year provided a nice respite for investors who weathered a very difficult 2022. But this year’s good start will face several hurdles in the upcoming days. Later this week the CPI report for December has the ability to reverse the current optimism on inflation. The consensus view is that inflation is steadily decelerating, but if that does not prove to be true, there will be disappointment. More importantly, fourth-quarter earnings reports begin at the end of the week, and these could set the tone – and the trend — for earnings over the next few quarters.
In our opinion, while some market commentators believe pessimism is currently too extreme and overdone, investors have not truly come to grips with the status of the current economy, the determination of the Fed to fight inflation and what that means, and the prospect for corporate earnings.
The Economy
It is widely accepted that the real estate sector of the economy is in a slowdown or recession. But we see warnings in recent data releases that the downturn is broadening. For example, for the first time since April and May of 2020, both ISM indices ended below the 50-bench mark denoting a contraction in economic activity. Plus, in both surveys the “new orders” components slipped well below 50, signifying a weakness in future activity. In other words, both the manufacturing and the service segments of the economy appear to be declining. See page 3.
The one positive we found in the two ISM reports is that both the manufacturing and the non-manufacturing survey showed prices falling or decelerating. In the ISM manufacturing report, the price index fell from an already low of 43.0 to 39.4; while in the non-manufacturing report the price component fell from 70 to 67.6 – a sign of deceleration.
There were also encouraging inflation signs in the Small Business Optimism survey for December. The NFIB report indicated that fewer small businesses plan to raise prices in the coming months and the index fell from 34 to 24. However, fewer small businesses plan to increase employment and that component fell from 18 to 17. All in all, the NFIB Optimism index fell 2.1 points to 89.8, in December, recording its 12th consecutive month below the 49-year average of 98. See page 4.
In December, payrolls increased by 223,000 and the unemployment rate edged down to 3.5%. These are actually robust numbers that could have worried investors, but the report was well received since average hourly earnings rose 5.0% YOY, down from November’s 5.5% YOY pace. This deceleration in wage gains was viewed by many as a positive thing, but we disagree. First, we do not think the deceleration is significant. Second, we do not believe the current economy is at risk of demand-pull inflation due to rising wages. In fact, the opposite is true. Inflation has had a very negative impact on real weekly earnings and in December real weekly earnings were actually down 2.6% YOY and were 4% lower than their May 2020 peak. In short, households have been losing purchasing power for nearly three years and are not a source of potential inflation. See page 5.
More signs that households are struggling are found in retail sales. In the nine months ended in November, total retail and food services sales grew at an average monthly pace of 8.4% YOY. This sounds healthy, but after adjusting for inflation, total real retail sales grew only 0.5% YOY. This lack of substantial revenue growth is a hurdle for many retailers and for future earnings. And though auto production has normalized, vehicle sales also declined in November. Weakness in the auto sector is also seen in used car prices which have been on the decline. See page 6. In sum, we have been anticipating a recession this year and recent economic data is falling in line with our theory.
Fed Policy – Too Soon for a Pivot
Many market commentators have suggested that the Fed will end rate hikes, or pivot once the economy shows signs of weakness. In our view, this is naïve thinking for several reasons. First, inflation does not materialize or end quickly. Prices were rising for several years before the CPI peaked at 9% last year. It is apt to take at least several years to get it back to the Fed’s target of 2%. Second, Fed tightening cycles have historically ended when the real fed funds rate reaches 300 basis points, or more. See page 7. It may not have to reach a full 300 basis points in this cycle, but the Fed has clearly indicated that a real fed funds rate is its objective. If this is true, the fed funds rate may need to move well above the 5% to 5.25% most economists are forecasting. For example, if inflation falls to 4% this year (our target) the fed funds rate could rise as high as 7% to break the inflationary cycle. There are other scenarios as well. Inflation could fall to 3% and the fed funds rate could peak at 6%. Nevertheless, this suggests the fed funds rate could move higher than most expect this year. In our opinion, nothing above a 5.25% fed funds rate has been discounted by recent equity prices.
Earnings
The fourth quarter earnings season could become a disappointment for those looking for a rally, or at least a January rally. Some analysts believe investors will look past an anticipated trough in earnings and actually rally on bad earnings news. But in our view, it is nearly impossible to estimate how weak earnings might be in 2023. The combination of fed rate hikes and a weakened consumer is what led us to reduce our S&P 500 earnings estimate for this year to $180, reflecting a 10% decline from an estimated $200 in earnings in 2022. A 10% decline in corporate earnings is “average” during an economic recession.
It is important to point out that while S&P Dow Jones is currently estimating 2022 earnings to be $200.19, this is only a preliminary estimate. See page 8. Fourth quarter earnings have not yet been reported and this forecast is likely to move lower. This scenario may explain why the fourth quarter earnings season could become a market moving event. Weak fourth quarter earnings results would not only require analysts to bring their earnings estimates down for last year and this year; but corporate guidance may have a substantial negative impact on this year’s forecasts — which ironically continue to anticipate year-over-year gains, despite expectations of a recession.
Technical Update The DJIA is the only index that is currently trading above all its key moving averages and looking positive. Conversely, the Nasdaq Composite is trading below all its key averages and looking bearish. The SPX and Russell 2000 have somewhat mixed pictures in terms of their moving averages. This divergence in performance is a result of a market leadership shift from growth to value that took place in 2022 and which we believe will continue this year. To a large extent, it reflects our thoughts of “follow the earnings” which tend to be clustered in energy, staples, aerospace, utilities, and stocks that reflect other necessities.
Gail Dudack
PLEASE NOTE: Unless otherwise stated, the firm and any affiliated person or entity 1) either does not own any, or owns less than 1%, of the outstanding shares of any public company mentioned, 2) does not receive, and has not within the past 12 months received, investment banking compensation or other compensation from any public company mentioned, and 3) does not expect within the next three months to receive investment banking compensation or other compensation from any public company mentioned. The firm does not currently make markets in any public securities.
