Stocks have rallied to start 2023 and the biggest reason for the early gains is that investors are interpreting further declines in inflation, slowing economic growth, and less-hawkish Fed rhetoric as increasing the chances for an economic “soft landing.”
For clarification purposes, a “soft landing” means inflation falls faster than growth, allowing the Fed to pivot, stop hiking rates and then start to cut them. In doing so, this keeps any economic slowdown brief while getting inflation under control. Do the facts really support this sudden burst of optimism? No, not really. Seriously, what has changed?
Yes, inflation is declining, as shown by last week’s CPI and the drop in price indices in other metrics (ISM Manufacturing and Services PMI). Yes, growth is slowing, as clearly evidenced by ISM PMIs and anecdotal commentary from companies. And yes, Fed rhetoric has somewhat softened as the Fed is clearly guiding towards a 25-bps rate hike on Feb. 1.
But none of that is materially different from what we expected for the start of 2023. On inflation, we already knew that inflation was falling, yet the services inflation (the key part of inflation) is not falling any faster than we expected. On growth, we knew it was slowing, but that slowing is suddenly accelerating, and it’s very early to guess how badly growth will ultimately slow (we’re just starting to feel the impact of last year’s rate hikes). Finally, on the Fed, a 25-bps hike in February isn’t a dovish surprise — investors have been expecting the Fed would most likely “step down” to 25 bps going forward this year.
It’s not clear to me how the data so far in 2023 makes a soft landing more likely, considering:
- Inflation is still massively above the Fed’s target
- The labor market and service price inflation remains too tight and too high respectively
- Growth is clearly slowing and it looks to be getting worse
- The biggest mistake the Fed has made in the last 40 years is pivoting too soon, and this Fed seems bound and determined not to make that same mistake
Just because we are finally in “restrictive territory”, i.e., FFR > Core Inflation, doesn’t mean a pivot is imminent. As always, if you’d like to see charts on this, please reach out.
Why I am skeptical about this rally: Well, as mentioned above, it feels as if the market is pricing in more and more of a “soft landing” – what does that look like underneath the hood for equities? Let’s look at what’s outperforming:
Said another way, on a YTD basis, the outperformance of the “30 Worst Performing Stocks of 2022” versus the “30 Best Performing Stocks of 2022” is at the biggest spread anyone has seen in 15 years.
And, finally, a play off of our quarterly newsletter, in which we reference a few “investment cults”, have reversed performance YTD. High fives goes to someone who guesses the quarterly theme.
I hope y’all are noticing a theme here: low-quality / junk has been outperforming YTD. More importantly, does this feel like a great cornerstone for the onset of a new market regime? I’d reckon not. Over longer periods of time, we prefer to own quality assets that have a sustainable path for growth – these types of securities tend to outperform over longer periods of time. This “rally” does not exhibit those characteristics.
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