After a tough end to 2022 which wrapped up a difficult year for both stocks and bonds, markets staged a nice comeback in January. After falling by about 20% in 2022, the S&P 500 rallied 6.2% in the first month of 2023. The NASDAQ was down 33% in 2022 but rebounded by 9% in January.
The main catalyst was the relief seen on the two biggest pain points of 2022, that being the highest inflation in 40 years and the monetary policy response being the most aggressive in 40 years. The rate of change with inflation has continued to moderate off the peak seen in June 2022 of 9.1% as measured by the consumer price index. And, after four 75 basis point rate hikes in a row, the Fed downshifted to 50 basis points in December and to 25 basis points in the meeting on February 1st of 2023. Jay Powell at the Fed press conference did say they might have another hike or two left but either way, we are at the tail end of their rate hiking path. That said, quantitative tightening continues on at a rather aggressive pace.
In response to the relief stated, interest rates fell across the yield curve. In January, the 2 year note yield fell 23 basis points and the 10 year yield was lower by 37 basis points. Combining the two though resulted in further yield curve inversion which implies more worry about economic growth. The US dollar sold off for a 4th straight month as the interest rate differentials between US rates and those overseas continued to shrink. This in turn helped to lift gold by 5.6%.
It wasn’t just the headline indices which had a sharp comeback, many parts of the market partied like its 2021 again. Meme stocks, crypto, and CCC rated bonds all saw rather notable rallies. After years of underperformance, many international stock markets surpassed the US in terms of January performance.
As a result of Beijing lowering its highly restrictive Covid protocols, many international stock markets were actually the star performers in January as their rally sometimes exceeded the ones in the US. The German DAX was higher by 8.7% in January and the French CAC by 9.4%. The Hang Seng was up by 10.4%, the Shanghai comp by 5% and the China H share index traded in Hong Kong was higher by 10.7%.
Inflation Trends and the Economy
Coincident with both a slowing economy and easing of supply chain issues, goods prices continued to moderate as seen with the reported December CPI in January. Headline CPI rose 6.5% y/o/y in December vs 7.1% in November and 7.7% in October. The core rate was up by 5.7% y/o/y vs 6% in November and 6.3% in October. Service prices is the other big component of inflation and prices here continue to accelerate but because of the lagged calculation in capturing rent growth trends, service prices should soon be moderating too.
When thinking about inflation from here, the key question is where it settles out at. Do we go back to the 1-2% pre Covid benign trend on a sustainable basis or are we in a higher inflationary environment more consistently, something on the order of 3-4% instead. While I don’t think we’ll really know for sure until 2024, I believe it will ultimately settle out somewhere in the 3%-4% range.
The economic data that came out in January showed continued slowing in activity. The January ISM manufacturing index was under the breakeven between expansion and contraction of 50 for the 3rd straight month. The S&P Global manufacturing and services composite PMI for January was under 50 for a 7th straight month. US housing trends continue to be soft but did get a bit better in January in response to lower mortgage rates. The overall pace of transactions though is very subdued due to the affordability challenge of a doubling in mortgage rates on top of a 40% national rise in home prices according to S&P CoreLogic. Also, and the most important piece of the US economy, that being the consumer, personal spending on a real basis was negative in November and December.
The Fed and other Central Banks
These moderating trends has us believing that the Fed is just about done raising interest rates and we’ve seen in response the same belief of the markets with yields down across the yield curve. And with the market rally, financial conditions have eased dramatically with one metric, that being the Bloomberg Financial Conditions Index (capturing various market metrics), at the easiest since February 2022 BEFORE the Fed started raising interest rates. This creates a problem for the Fed because if this reinvigorates economic growth, inflation could start turning up again, making the Fed’s challenge in taming it even more difficult.
The day after the Fed announced its rate hike news on February 1st, the European Central Bank and Bank of England each followed with 50 basis points hikes of their own and said rates should continue higher. The ECB also reiterated that quantitative tightening will begin in March while the BoE’s QT is continuing on. The Bank of Canada in January also slowed the pace of its rate hikes to 25 basis points but also kept QT on its current pace.
The end result is higher global interest rates and liquidity that keeps getting drained and even when central bank induced rates stop going up, they should stay higher for a while. The economic consequences of this will take time to play out, especially for those who have debt coming due this year and needs to be refinanced at an interest rate much higher than the rate on the loan coming due.
China’s economy is about $18 trillion, the 2nd biggest in the world and they have about 17% of the global population. Zero Covid basically trapped the citizenry in place for 3 years and now they have been let free. We are optimistic on this reopening and what it means not just for the Chinese consumer but the positive impact the pent up demand in spending will have for the entire Asian region and parts of Europe too that do a lot of business with China. Germany, for example, has its number one foreign customer outside of the Eurozone being China.
So while economic pressure will be seen in the US, and Europe too, outside of trade, in response to higher interest rates, the mitigating impact could be this China reopening that will more establish itself in Q2 and Q3. What this also means is that it could reverse the downward trend we’re seeing in inflation, particularly for commodity prices such as crude oil and something we believe will happen.
The market rally to start the year is perfectly understandable in that inflation is slowing and the Fed is likely almost done raising interest rates. But, this does not mean that the tough market is over and it’s all clear from here. We now have to acclimate to a higher interest rate environment which is quite different than what we’ve become accustomed to over the past 10+ years where zero and negative interest rates became the norm. Investors too have to deal with a higher hurdle rate for investment with the risk-free rate at 15 year highs.
It is for this reason that I feel it will still be a choppy year for investors and that we need to stay sober with this new rate reality. Whatever comes our way though, it remains vital that investors have adequate short term liquidity over the next 2-3 years. Knowing that period is covered can help separate the balance of one’s portfolio from the ups and downs of the market. Time horizon is very crucial right now and is the best friend of any investor. I want to also finish by saying that there are always opportunities to take advantage of and we are constantly on the lookout for them.
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