- Stocks started the year off strong, with the laggards of 2022 leading. The S&P 500 was up 6.3%, while the Nasdaq was up 10.7%. Eight of eleven sectors were up during the month. The two worst performing sectors of 2022 were up the most. Consumer Discretionary was up 15.1% and Communication Services was up 14.8%. International markets outperformed the S&P 500 with the EAFE and EM indices up 8.1% and 7.9% respectively.
- The markets are now pricing in that the Fed will be able to pull-off a “soft-landing”, bringing inflation down without tipping the economy into a recession. Even though we believe that the markets may be a bit too optimistic on the potential hit to earnings in the quarters ahead, this rally is a very welcomed surprise.
- Inflation slowed for the sixth straight month with CPI coming in at 6.5%, in line with expectations.
- The job market remains tight as the economy added 223,000 jobs with the unemployment rate falling to 3.5%. However, wages showed signs, that while still elevated, are cooling up 4.6% from 5.1% previously.
- Q4 GDP came in stronger than expected, rising 2.9% on an annualized basis. Although about half of it came from inventory growth.
- Yet, overall economic data still shows a decline. The ISM Manufacturing PMI fell deeper into contraction territory for the eighth consecutive month coming in at 47.4.
- Retail sales fell 1.1% in December. Partially explained by falling auto sales and lower gas prices but also showing a further economic slowdown. This matched the biggest decline in a year.
- The Fed raised rates by 0.25% as expected. Powell noted that more rate hikes were likely appropriate but that they were pleased at some of the disinflation they are seeing. Yet, that overall inflation is still too high with services and wage inflation their biggest concern.
Why It Could Keep Going Higher
- The primary driver of U.S. economic growth is the U.S consumer and Americans still have excess savings they are able to spend.
- Employment is still strong and that has always begun to slip before a recession.
- Inflation continues to decelerate and the Fed may be close to pausing rate hikes.
- The S&P 500 has fallen to a much more attractive valuation, significantly improving the future return potential.
- Inflation and the Fed’s response to get it under control are still the biggest risks the economy faces currently. The markets are expecting the Fed to cut rates in 2023 despite the Fed’s repeated commentary to the contrary. Fed policy impacts the economy with a significant lag so it is hard to determine what the future effects will be from the current rate hikes.
- Most foreign central banks are tightening policy at the same time, which may further amplify a global contraction.
- Employers may be forced to lay off more of their labor force to maintain margins in a slowing economy.
- Further Geopolitical tensions.
- The Unknown.
- CPI was in line with expectations falling 0.1% over the month and up 6.5% over the year.
- Retail sales fell 1.1% in December.
- Q4 GDP came in stronger than expected rising 2.9% on an annualized basis.
- PCE (the Fed’s preferred inflation metric) increased 5% over the year in December, down from 5.5% rate in November.
- The economy added 223,000 jobs and the unemployment rate fell to 3.5%.
- The ISM Manufacturing PMI fell deeper into contraction territory for the eighth consecutive month coming in at 47.4.
- The International Monetary Fund updated their 2023 outlook, saying a global recession may very well be avoided.
- The eurozone’s Q4 GDP surprised to the upside coming in at 0.1% vs -0.1% expected.
What We Are Doing
We have continued to maintain a well-diversified allocation. Our tilts towards defensive sectors such as healthcare, consumer staples, as well as low-duration fixed income which helped outperform in 2022, limited some of the upside in January.
However, we believe that the markets are pricing in a possible, but unlikely soft-landing scenario and that we may still see more volatility and weakness ahead. So, we are maintaining our more defensive position for the time being.
We reduced some of underweights to both international and emerging markets during the month, as the China reopening has improved their economic outlooks. We will continue to watch the economic dynamic carefully to take advantage of any opportunities.