Inflation is down and markets are up. Bullish investors have burst out of the gate in the first month of 2023. Will the bears roar back to stun the bull run?

The January Effect is in full swing as the S&P 500 index gained over 6 percent and the NASDAQ Composite jumped over 10 percent to kick off 2023. It was the best January since 2001 for the technology driven index, calling to mind the dot com bubble era. Healthy debates are being had all over Wall Street over whether this latest movement represents a true inflection point or just another bear-market rally (elevated short-term performance in an otherwise poor return regime). The Washington fight over the debt ceiling and the threat of broader conflict in Europe ominously hang over global markets.

Almost all market strategists can appreciate the generally improving economic picture with rising hopes of a “soft landing.” Consumer sentiment has improved, and surveys are showing inflation on a controlled and linear decline. Demand for services is as strong as ever. New home sales jumped in January after several monthly declines reflecting slightly lower longer term interest rates.

We received a blowout January jobs report with added jobs crushing estimates and steady yet expected wage gains showing just how resilient the service economy and the labor market have been. Over 500,000 jobs were added, jobless claims were down, the unemployment rate unexpectedly fell to the lowest rate since 1969, and with falling inflation, there is optimism that the Fed is threading the needle as hoped. The stable wage component is paramount to inflation expectations and will add to the sanguine mood among investors.

December’s CPI (Consumer Price Index) report showed a sixth-straight monthly decline. Manufacturing data showed contraction again, but the ISM survey’s gauge of new orders received by service businesses boomed to 60.4 in January from 45.2 in December*.

While it is great news, this latest labor report may complicate the Fed’s future decisions. Planned tech and retail layoffs are coming, but demand for service labor is at record levels and must play into the central bank’s calculations. Risk assets have performed well lately no matter what the central bank’s communication has been. Bond market expectations have been much more pessimistic as the divergence between equity price performance and yield curve inversion becomes wider.

Performance has been driven almost entirely from expectations that inflation will continue a strong downward trajectory while the job market stays tight, and wages stay high. Some of the rally could be attributed to that aforementioned “January Effect,” which is the often observed increase in stock buying after a sell-off in December from mass tax loss harvesting and new year sentiment.

Conflicting economic data, heightened geopolitical risk, and uncertain inflation path still warrant close attention

Earnings and bottom-line growth margins domestically are compressing. The biggest names in Tech (Apple, Amazon, Alphabet, and others) had disappointing 4^th quarter results and lower growth guidance. Overall, profitability is expected to slow considerably by end of the year. Goods demand has fallen, despite record profits for certain energy and consumer staple focused companies. Inflation could remain sticky as well with 11 million jobs still available applying upward pressure on ongoing wage growth. Even as big tech firms lay off employees in droves, service sector companies are not nearly as fully staffed as they desire or need to be.

The Fed raised the policy overnight interest rate a quarter point as expected in early February, marking a significant slowdown from the 75 basis point rate hikes last year. Still, the Fed has raised rates at the fastest pace since 1980 and the rhetoric remains hawkish*. More rate hikes are expected per the latest FOMC minutes. After digesting the latest jobs report, higher rates for longer are almost certainly the expectation across Wall Street. That does not bode well for high growth stocks and firms with weak balance sheets.

Fed officials continue to walk the line of tightening financial conditions enough to destroy inflation without tanking the economy. The bond market has taken these hikes seriously as the yield curve inversion has been deep and persistent. A reliable indicator of recessions over the long run, the curve inversion suggests that recession hasn’t been ruled out, but most likely delayed with tighter financial conditions finally catching up with the real economy. Yields have already collapsed meaningfully from the 2-year to the 10-year treasury bond yield, especially after the latest Fed meeting.

What does it all mean for portfolio positioning and asset allocation?

It’s a confusing time after such a rally in the equity markets, so what about portfolio positioning? Starting with bonds, once the Fed is finished with rate hikes, the entire yield curve could eventually ratchet even lower. There is so much money waiting on the sidelines that rates could fall significantly across the board (demand rises, prices go up, yields go down). This is great for total return bond investors who have already gotten into the bond market in the high-quality sectors.

We have moved to overweight our overall bond exposure, especially in higher quality, investment grade bonds. Municipal bonds are another sector where we continue to have a positive outlook. Municipals posted their best start to a year in over a decade last month. We remain underweight high-yield (junk) bonds, as we feel the additional spreads over investment grade bonds are not wide enough and not worth the risk. By most estimates with where we are in the business cycle, having significant high yield exposure would be imprudent historically.

Add to international exposure?

US equity market valuations feel a bit too optimistic and stretched, even considering the jobs data. With the latest upward moves, the major US Large Cap equity indexes are much higher than pre-covid levels, not terribly far off from record highs. Other style boxes and Ex-US opportunities beckon investor’s attention. We like a healthy small to mid-cap equity allocation and we have begun to slowly increase emerging market equity and debt exposure. If economic conditions make the US dollar less attractive, local currency equities and debt would provide a beneficial and combined return potential for currency appreciation and price growth.

China’s economic reopening and abrupt reversal in COVID policy drove a huge change in expected GDP growth this year. Risks remain there as tensions with the US are as high as ever. Foreign investors have increased purchases of Chinese equities this year but having greater exposure to other EM countries such as India and southeast Asian nations provides diversification and valuation opportunities. The European and Japanese markets outlook is more nuanced, and we have targeted, active equity exposure there taking advantage of depressed prices. It is far from a “buy the broad index” environment.

Economy in good shape, but continued caution recommended for investors

Despite the mixed market outlook, parts of the economy are robust. The question has become – is the economy strong enough to support current US stock prices alongside declining inflation? We don’t have to wait for the answer. We can take advantage of higher bond yields and lower prices internationally, while staying defensive domestically to support portfolios in the meantime. Looking ahead, we keep watch of the debt ceiling showdown, and we will parse through the inflation and manufacturing data for January. We are off and running in 2023!

Questions? Comments? Reach out to us.

*Source: FactSet, Bloomberg

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