SPECIAL: Zooming Out, 2022 was a year of "roundtrips." Fed remains principal "risk" to markets, but we see reaction function changing as inflation continues to fall.

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2022 has been a year of “shocks” and “sudden changes.”

• Stubbornly high Inflation was an unexpected “shock” in 2022 that weighed on equity performance, but recent trends show it is falling just as quickly as it rose
• Persistently elevated geopolitical tensions from conflict between Russia and Ukraine created supply imbalance “price shock” for crucial input commodities. Prices have roundtripped since.
• Fed went from “hands-off” to “all hands on deck” as inflation climbed through 1H2022, but “reaction function” set to change as recent trend proved inflation is falling faster than most believe
• China went from perma zero-Covid to reopening overnight (whoa), underscoring how fast apparent crises can change
• Headlines below prove just how sudden this actually was  

But as Tom has said, “crisis” also comes with “opportunities.” Throughout 2022, we have seen many improvements.

• Supply chains substantially eased
• COVID-19 faded in the United States 
• Several key raw material inputs fell sharply from post-war highs: Gasoline, Oil, Wheat, Etc. 

Several key inflationary inputs roundtripped in 2022, suggestive of lower prices in 2023

As suddenly as prices “shocked” to the upside in the first half of this year, prices have reversed course in the second half.

• Gasoline, Crude Oil, and Wheat all made “roundtrips” in 2022
• All surging at least 50% mid-year
• And declining at least 36% since
• This is shown in the table and charts below

And while Fed references BLS “hard data” as still coming in “hot,” it is hard to ignore what the above soft data is telling us.

In 2023, principal risk to markets remains the Federal Reserve, but cooling inflation will change its reaction function:

Looking into 2023, the principal risk to markets remains the Federal Reserve. Our view is that inflation is falling much faster than consensus believes, and with that will come a more predictable Federal Reserve (one that markets can deal with).

And while many investors perceive inflation as strong and a key “risk” to markets heading into 2023, our outlook is that the inflation problem is “fixed.” And, as it falls, will act as a tailwind for risk-on assets in 2023.

As Tom noted last week, the Nov PCE reading makes the Fed’s prediction of 4.8% Core by YE nearly impossible.

• To reach such a forecast for Core PCE, Dec MoM would have to be 0.66% 
• This would imply a Dec MoM reading of 4x the Nov Print

Additionally, the Fed’s prediction of 5.6% for headline PCE is far out of reach to us

• Dec MoM PCE would have to be 0.60% to reach such a forecast
• This would imply a MoM reading of 6X the Nov Print  
• The scenarios are shown below:

And considering the recent trend of PCE shows price deceleration, we find the Fed’s estimate to be highly improbable. To illustrate this point, we plotted the % of PCE weight with 3M annualized %change <2%. In other words, components that are falling like a rock. 

• As of November, 40.9% of components are seeing 3M annualized %chg below 2%.
• This is the highest % since early 2021 –> means more components are now below Fed’s 2% target
• This is also the first time in nearly 2 years that this trend is above the long-term average of 38.6%.
• Internally, the recent trend is signaling that prices are far weaker than Year over Year, 5.5% “optics” suggests.

We also looked at the contribution to Core PCE 3M annualized

• Taking a look at the non-housing portion of Core PCE, prices fell sharply in Nov,
• While Housing has yet to roll over.

And in order for PCE to fall continuously, Housing remains a key category.

• Housing accounts for 20% of the PCE basket.
• As we know, PCE (and CPI) housing components significantly lag. The ‘spot” data has shown improvement in housing price.
• For example, the latest Case-Shiller home price came in this week at 9.2% YoY, down from its peak of 20.8% in March 2022
• But if we look at the 3M trend (3M annualized % change), this figure has been consecutively negative and now = -7.7%

And historically, Case-Shiller home price index led the PCE housing components by 10 months

• below we plotted the 3M annualized % change for both Case-Shiller home price index and PCE housing index
• as you can see, if the historical relationship holds, we could see PCE housing tank in the near future.

Several Key Economic Events in next two weeks:

There are several key economic events over the next few weeks that will set the tone for incoming data in 2023. We’ve outlined them below along with a few thoughts on their importance.

• Nov JOLTS (1/4). Why is it important? JOLTS remains one of the most important indicators of labor market tightness to the Federal Reserve. LinkUp data shows active listings have dropped sharply in the last 2 months. Street sees JOLTS 10,000k (-3.2%) vs Oct.
• FOMC Minutes (1/4). Why is it important? FOMC minutes will fact check Powell and potentially reconcile Fed’s high PCE projections.
• Nonfarm Payrolls (1/6). Why is it important? This bears watching, especially after potential “faulty” overstating in payroll employment from Philly Fed by 1.1 million (see here). Street sees 200K net jobs added in Dec, down from 263K in Nov.
• Labor Market Stats (1/6). Why is it important? Other than NFP, Fed has eyes on unemployment rate, hourly earnings, and labor force participation. Any signs of softness could give investors more confidence that the Fed is doing its job.
• December CPI (1/12). Why is it important? December release is the most important event in the next two weeks. A “soft reading” will mark 3 consecutive prints of easing inflation. As noted previously, this could change the Fed’s reaction function from “higher for longer” to more predictable. Also, this time the Fed has more time to digest the incoming data (2 weeks) before Jan/Feb FOMC meeting.
• Other events: ISM PMI Manufacturing (1/4), Services PMI (1/6), NFIB Small Biz (1/10), UMich Consumer Sentiment and Inflation Expectations (1/13)

SENTIMENT: Rolling 51Wk Avg of Bearish Sentiment Hits all-time low (falling below GFC levels), but are conditions really worse than 2008?

Investor sentiment has been plagued by incoming negative “shocks” in 2022. Take a look below: 

• Over the course of the AAII Investor Sentiment Survey history (running for 30+ years) 
• We are currently at the most “entrenched” and persistent level of bearish sentiment in the survey’s history (since 1987)
• Think about that. More negative than ‘02 (tech bubble) and ‘08 (GFC)
• Additionally, periods of such depressed sentiment have corresponded with secular lows in stocks
• And comparing market environments, are things really as bad as investor sentiment suggests? 

We think no. Why? Because investors are more focused on the shocks that are now “realized” (in the past) and less on how things can change. We think the key to 2023 will be to focus on the latter (how things can change) rather than the former (what has been realized).

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