With 33% of 2023 in our wake, it’s time to assess the accuracy of our year-end macro mapping. For 2023 we made several lonely contrarian calls. First, we expected corporate performance to pleasantly surprise investors despite lousy economic performance. Second, we expected wages to fall faster than unemployment would rise, limiting recessionary degree. Third, we anticipated robust post-recession investment returns out of historical sequence with the recession itself. Our portfolio strategies exiting 2022 aligned with these headings. With a third of 2023 in the books, it’s time to revisit our macro coordinates and evaluate whether we, and our investors, remain on course…or strategically adrift.
At the beginning of each year, we dive deep into thought, reflection, and prognostication to establish our strategic compass headings for the year ahead. These headings establish our guiding narratives for the year and set the strategic course for our portfolios. Unfortunately, predicting the future is risky business and requires flexibility, because if conditions change and strategists don’t, strategies fail. Now that we have completed 33% of 2023 it’s time to check in on our headings and determine whether it’s time to course correct.
In August of 2022, Jerome Powell broadcasted his intention to push the US economy into recession. This forced corporate boardrooms to begin battle planning immediately, issuing directives like: “We need to raise prices now while we can”, “We need to draw on credit facilities at low rates to stockpile cash”, “We need to shrink our real estate footprints”, “We need to rightsize bloated operations”, and “We need to fully leverage technology to reduce labor dependencies”.
Unfortunately, acting upon these directives takes time. Fortunately, eight months have now passed since Powell called his shot. On Thursday, the BEA reported that the US economy grew a scant 1.1% in the first quarter, well below economist’s 2% expectations. But while the US economy underperformed expectations last quarter, US companies outperformed expectations.
On March 31st, analysts expected earnings for the S&P 500 to shrink 7% in the first quarter. With half of the S&P 500 having now reported, estimates for the quarter have risen to a loss of only 4%. Of those who have reported, 80% have beaten estimates by a margin of 8%, overall. This amounts to substantial outperformance, as the data set below demonstrates:
Remember, it’s not whether companies make money or lose money that drives near-term stock performance; it’s whether they make more than less than expected.
So far, 33% into 2023, corporate results have exceeded expectations, leaving our “Corporate Leadership will Outperform” course heading intact.
COVID layoffs predominately impacted frontline workers as forced closures led to forced furloughs. In return, the federal government lavished displaced workers with historic amounts of mailbox money. The excess savings led to a lag in labor participation just as the stimulus-fueled economy reopened, creating notable shortages.
Companies struggling to fill frontline positions to meet demand had to raise wages considerably to entice workers to return. With the front line largely re-established, employers are loathe to lay off those that just returned within such a competitive labor pool.
Yet, with Powell’s recession on order, corporations must trim labor costs. This has led to white-collar layoffs across the economy as businesses restructure, retool and reimagine operating systems. Laying off one $150,000 worker versus laying off three $50,000 workers reduces wage inflation 3X as much as it increases unemployment.
By trimming at the top of the tree, companies become more efficient, wage inflation declines more strategically, and the economy can correct more “softly” absent the typical surge higher in corrosive unemployment. As the chart below demonstrates, this is precisely what has been occurring, as wage inflation has fallen from 6% a year ago to 4% today, while the unemployment rate has fallen from 3.6% to 3.5%:
The continuation of this trend creates potential for a goldilocks scenario whereby wage inflation falls to trend as the economy cools, while a low unemployment rate supports consumer spending (frontline workers spend proportionately more of their income than higher income savers). This orderly labor market restructuring underpins our view that the post-COVID economy will land softly rather than crash.
So far, 33% into 2023, companies have eliminated more white-collar wages than blue-collar wages, leaving our “Wage Inflation will Fall Faster than Unemployment Rises” heading intact.
Because Powell pronounced recession as his primary inflation-fighting strategy, markets quickly priced in its eventuality. From its high to its low, the S&P 500 fell 25% in 2022. At the median, markets decline 24% during recessionary periods. Therefore, while recession did not occur in 2022, recessionary returns did, scrambling the usual, more concurrent, sequence of events.
With recession returns arriving one year early, recovery returns should therefore arrive one year early as well. While we predicted that the US would slip into a recession in 2023, we also anticipated surprisingly positive returns for investors given Powell’s altered sequencing.
Post-recession returns average 26% one year later, 35% two years later, and 46% three years later. Whether we see returns of that magnitude remains to be seen, but clearly investors profit handsomely during economic recoveries with much of the gains occurring in the first few months.
While the US economy may have downshifted from 3.2% growth in the 3rd quarter to 2.6% growth in the 4th quarter, to 1.1% growth in the 1st quarter on its way to negative growth in the second quarter, the S&P 500 has managed to climb 19% off its October 2022 intraday low and now stands 8% higher on the year.
So far, 33% into 2023, the stock market has risen sharply as the economy lists toward recession, leaving our “Investors will Receive 2024’s Recovery Returns” heading intact.
In sum, our course headings for 2023 remain unchanged. This market may brace for recessionary impact over the next couple of months, but we expect the recession to be no more than a glancing blow. We expect corporate leadership to continue their outperformance, wages to continue falling faster than unemployment rises, and market returns to continue bedeviling the bears.
Have a great weekend!
David S. Waddell
CEO, Chief Investment Strategist