March Private Client Letter

The new year has begun very much as we had expected with inflation proving to be more sticky than many investors had expected, and another bear market rally in equities is unraveling, just as the seven prior such rallies have. 

Hopes that the Fed would soon pivot away from further rate hikes were swept away with the January inflation data.  This reversal in inflationary trends has caused some analysts to suggest the possibility the Fed could bump the Fed Funds rate by another 50 basis points at the next FOMC meeting on March 21-22.    

This is unfortunate, but not unexpected.  Our base case for 2023 calls for stubbornly high inflation, tighter monetary policy from the Fed (interest rates higher for longer), and a stock market that has not yet established a bottom.  In my December Private Client Letter I observed: “I believe this current rally is not likely sustainable into 2023”. 

The Leading Economic Indicators (LEI) for January fell another 0.3% marking the 10th straight monthly decline.  This data would suggest that the lagged effect of tighter financial conditions continues to work its way through the U.S. economy and may have further to go.  With economic activity still decelerating, forward earnings estimates remain under pressure as analysts weigh the rising risks for a recession later this year.

The Trajectory of the U.S. LEI Continues to Signal a Recession Over the Next 12 Months

According to Ataman Ozyildirim, Senior Director, Economics, at The Conference Board, “The yield spread component of the LEI turned negative in the last two months, which is often a signal of recession to come. While the LEI continues to signal recession in the near term, indicators related to the labor market—including employment and personal income—remain robust so far.  Nonetheless, the Conference Board still expects high inflation, rising interest rates, and contracting consumer spending to tip the U.S. economy into recession in 2023.”

Late in February, the second preliminary forecast for real GDP in the 4th quarter of 2022 was revised lower to a 2.7% annual rate from a prior estimate of 2.9%.  Our analysis of the details of the report can best be summed up by “weaker consumer spending along with rising inflationary pressures in the fourth quarter.”

With several important measures of inflation reversing course in December and accelerating into January, it should be evident that the Fed’s significant tightening of monetary conditions in 2022 has yet to slow down aggregate demand.  Accordingly, we believe it is likely the Fed will continue its rate hiking campaign for longer than markets had anticipated just a few weeks ago.

Wage inflation has become an issue in a historically tight labor market.  Addressing this problem will be the next phase of the inflation fight, as labor demand remains well above labor supply.  The unemployment rate reached a 50-year low in January and we will be closely watching the February employment report when it is released on March 10th.  Should the report indicate new job gains of more than 250,000, the odds of a 50-basis point hike at the next Fed meeting would rise.  This, in turn, would likely trigger a new surge in volatility for equity prices.

The macroeconomic landscape remains quite challenging as we move deeper into 2023.  We continue to believe that our strategies are best served by being relatively defensive for the next 3 to 6 months as inflation and growth conditions remain unfavorable.  We face headwinds from rising real interest rates and considerable uncertainty regarding how much the economy will eventually slow.

As would be expected in times like these, earnings forecasts have been falling and may have further to go.  It does not appear that equity markets have yet fully priced in lower earnings expectations, which explains why we caution investors that things could still get worse before they get better.   

We believe a recession in 2023 is now virtually unavoidable, although it is our view that the coming recession will likely be short and shallow.  It is still possible that by mid-2023 we will have seen the worst of this bear market and investors will turn their attention to economic recovery. 

This said, relations between the U.S. and China are worsening as China considers sending weapons to Russia in support of their war with Ukraine.  Here at home, the budget deficit and federal debt limit will be a major issue this summer with the threat of a government shutdown hanging in balance.  To say that investors have a long list of things to worry about in 2023 would be an understatement.

The silver lining to all of this is that this economic downturn need not be severe.  Despite a reversal higher in recent inflation data, there is no sign that forward looking expectations are surging.  Significant parts of the U.S. economy remain quite resilient, with some sectors still performing quite well. 

Our cautionary observations here, and in the Outlook 2023 report, are intended only to temper near-term expectations.  Eventually, investors will eagerly look past the lingering difficulties in anticipation of the next bullish wave.  As we have pointed out, there is a lot at stake when the bear market finally gives way to a new bull market, and we do not believe market timing strategies best serve the long-term objectives of our clients.

As always, thank you for your continued confidence as we navigate this unpleasant part of the economic cycle.  Please reach out should you have any questions or concerns.

John E. Chapman

Chief Executive Officer

Chief Investment Strategist