Bottom Line:

Data releases in the week, including the Fed’s preferred inflation measure, 4^th quarter US GDP and a fountain of corporate earnings releases, didn’t dissuade investors from further subscribing to 2023’s surprise rally. After a relatively few trading days, the US stock market has rallied strongly, with international markets rallying stronger still. Bonds have made gains, commodities have made gains, and even Bitcoin has found footing. This “everything rally” has certainly surprised the bearish consensus. It’s early, but while the Fed may try and kill the party next week, the raw data supports the markets’ growing conviction that 2023 may not be so bad after all. And that’s good!

The Full Story:

So far, 2023 has surprised investors with its buoyancy. Year to date, the S&P 500 has rallied over 6%, which sounds impressive, but less than the returns of some alternatives. Small-cap US stocks have rallied 8%, developed international stocks nearly 10%, and emerging market stocks almost 12%. Even bonds have begun generating returns again, with the Aggregate Bond index up 3.5% already. These returns have all eclipsed the flat-on-the-year consensus forecasts provided by Wall Street strategists–tune in for our 2023 forecast on February 16^th. But for these returns to remain aloft requires inflation to cool, the economy to only slightly recess, and corporate earnings to provide resiliency. This week we received insights into the status of all three.

The Fed’s Favorite Inflation Evaluation

On Friday, the Bureau of Economic Analysis released its most current read on US inflation via the Personal Consumption Expenditures Index (PCE). This index differs from the Consumer Price Index (CPI) calculated by the Bureau of Labor Statistics. While the Consumer Price Index sources its data from consumers via household surveys, the PCE sources its data from suppliers. While the CPI only covers out-of-pocket expenses for consumers, the PCE includes payments on behalf of consumers by businesses and governments. This makes it somewhat less volatile, and a more comprehensive read on inflation, earning it the privilege of being the Fed’s preferred measure. Here are the most current readings on two indicators (food and energy):

Fortunately, the PCE inflation index registers lower current inflation than the CPI inflation index at 4.4% vs. 5.7%, respectively. Unfortunately, the Fed’s 2% target remains some distance away. Nonetheless, Friday’s cooler-than-expected reading added a lift to the markets and offered further evidence that inflation has decidedly tacked downward.

In 2022, the US Economy Grew on Queue

The US economy grew 2.9% in the 4^th quarter. The growth registered .3% above expectations despite slowing .3% from its 3^rd quarter gain. For the year, the US economy grew 2.1%, spot on with its long-term potential growth rate. However, given the Fed’s mission to cool the economy to douse inflation, these numbers appear perversely problematic. However, within the report, much of the gain in GDP stemmed from government spending, trade gains, and inventory builds. Consumers, which account for nearly 70% of GDP, continued to spend, but their spending pace clearly diminished into quarter’s end. Also, the sizable rise in inventories indicates decreasing demand, reducing the need to stockpile further into Q1. If you strip out gains from trade and inventories, US GDP only grew .8%, a much more innocuous read for the Fed. Overall, this positive report without any Fed moving surprises only adds further rally support.

Earnings Down, Surprises Up, Markets Up

While we have only completed 25% of the 4th quarter earnings season, numbers have largely arrived better than expected. While analysts expected a decline in S&P 500 earnings, the decline should be less than feared. Remember, it’s the spread between reality and expectations that moves markets more than reality itself, and 69% of reporting companies have beaten expectations. With 75% of the earnings season yet to go, it’s too early to declare victory. However, the reality of the market rallying through a season of earnings decline is not unprecedented. In fact, bear markets that accompany earnings declines tend to bottom six to nine months before the earnings themselves bottom. With the S&P October low intact, we think that would place the earnings nadir within the 1^st half of 2023 right on queue. As long as something exogenous and unforeseen doesn’t clobber corporate earnings, “better than expected” adds rally support even as earnings decline.

Fed-ruary 1

Next week the Fed will raise interest rates .25% to 4.75%. We expect to hear more hawkish refrains about rates being higher for longer, along with some slight acknowledgment that inflation has tempered. Markets will take this in stride as the data released matters more than the Fed’s rhetoric at this point. In fact, the market’s expectation for the Fed’s interest rate policy path now widely diverges from the Fed’s own forecast:

Markets now predict a rate cut by year-end while the Fed foresees adding a couple more increases. This difference of opinion will start pressuring the Fed to relent or lead them to double down on their rhetoric to bring markets to heel. The press conference next week should help with the reconciliation. We will be listening closely… and will report back!

Enjoy your Sunday!

David S. Waddell  

CEO, Chief Investment Strategist

Sources:  FRED Database, Bloomberg

Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.