Next few weeks, incoming data might prompt Fed to soften rate outlook (in a good way)
As markets look ahead to 2023, putting the awful 2022 behind, the plurality of investors are neither bullish nor bearish, but rather are “biding their time” until market visibility improves. That visibility comes in many possible forms from: market capitulation, EPS inflection, Fed pivot, or inflation contracts markedly.
We think the Fed ultimately will allow FCI (financial conditions) to ease. In the next month, we see incoming economic data points to support this:
- first, Nov JOLTS is released 1/4 and consensus is right at ~10mm, job openings are down -8% yoy. And Dec NFP is released on 1/6. But the message is probably labor is softening.
- second, Dec CPI is set to be released on 1/12 and we expect core CPI to come in below 0.3% (MoM), leading to 3 consecutive months where annualized CPI ~2.5%. A massive decline in inflation.
- third, Jan (prelim) U Mich CC inflation on 1/13 and we expect 1-yr inflation to drop as much as -40bp to 4.0%, possibly sub-4%
Collectively, we think this is sufficient for the Fed outlook on inflation and pace of hikes to change (see below). Basically, inflation is coming in at a pace below what the Fed expected in its recent December FOMC. In fact, we believe inflation might be undershooting by as much as 50-60bp vs their view of 2022 Core PCE inflation of 4.8%.
And if this is correct, we believe Fed will allow financial conditions to ease. That is, it is less about rate hikes, but more about whether the Fed views current policy as sufficient to achieving its goals.
- FCI tends to react strongly to Fed communications and guidance, and Fed speak, so this doesn’t require markets to wait for the February FOMC meeting.
- We use the Goldman Sachs FCI (GSUSFCI Index <<GO>> in BBG)
And if you are wondering if there is a difference between FCI and Fed Funds, consider the chart below which shows that in the past 4 years, there are key instances where the two differ:
- March 2020, while Fed was cutting rates, FCI was tightening –> divergence
- Oct 2022 to now, while Fed raised rates, FCI unchanged –> divergence
So, we think the FCI is far more influential on equity prices.
This is very evident looking below. FCI and S&P 500 tend to be closely linked. Part of this is the fact that one of the five components of the Goldman Sachs FCI is S&P 500 itself. But the broader point is FCI is what equity investors need to watch.
Nov JOLTS: If Consensus 10.025mm is correct, openings down -8% YoY
The Nov JOLTS (job openings) is released on Wed 1/4. The Fed would like the ratio of job openings to job seekers to be closer to 1.0 and with 6 million available workers, job opening need to fall another 2.5 to 4 million.
Could JOLTS be softer than 10.025 million? The LinkUp forecast, based upon their review of listings, looks for 9.911 million. That would be a positive surprise. The Conference Board is looking for flat. So we will see.
INFLATION: 3M annualized is far more important than YoY… let us explain why
A lot of economists and pundits cite the YoY (or 12M change) as their measure of “inflation.” But as our clients know, we have highlighted multiple times why this YoY measure is not necessarily the best measurement:
- YoY %-change take months to reflect an actual change in trend since it is based on a trended price level
- YoY %-change is backwards looking, and what matters is future inflation
- In our view 3-month annualized inflation is a better measure (last 3 months, annualized)
You might think 3-month annualized is not accurate. But consider the fact that YoY% change is actually the sum of the last 12 1-month inflation %-changes.
Don’t believe us? Look below:
- grey line is YoY %-change CPI (12M YoY)
- red-dashed line is sum of last 12 CPI MoM% (rolling)
- they are the same…see?
- So 3M annualized better captures the existing trend. YoY is simply too slow moving.
DEC INFLATION: 3M annualized will show Core CPI and Core PCE inflation tracking at ~2%…”mission accomplished”
Turning back to Dec CPI, we think Dec CPI will come in at 0.2% or so, below Street consensus of +0.3%. As shown below:
- Dec 3M annualized core CPI should come in at 2.68%
- and PCE follows CPI, this should be 2.04% (released later on 1/27)
- 2% 3M annualized has not been seen since mid-2021, so it points to a massive drop in inflation
Both figures are ~2% and means Fed “mission accomplished” as inflation is running at 2%. And thus, we think sets up for a Fed to make a “dovish” adjustment to its inflation views in the Feb FOMC meeting.
WHY FED “DOVE” MOVE: 2022 Inflation could be as much as 60bp below FOMC “dot plots”
It is important to compare the above incoming Dec CPI (and PCE) to what the Fed had in its Dec “dot plot” or SEP (Summary of Economic Projections). An abstract is shown below:
- Median for Dec Core PCE inflation (YoY) is 4.8%
- Actual range (21 participants) is 4.6% to 5.0%
- But if our +0.2% Dec Core CPI (and Core PCE) is correct, Dec 2022 Core PCE YoY will be 4.27%
- That is far below the range of Fed forecasts, even 32bp below the lowest Fed voting projection.
“Tireless” Ken, head of our data science team, created a sensitivity table to show where Dec 2022 Core PCE YoY comes out based on Dec MoM:
- our base case is +0.15% Dec
- Oct/Nov were: +0.262%, +0.168%
- For lowest Fed of 4.6%, Dec implied is +0.45% MoM
- Median Fed of 4.8%, Dec implied is +0.675% MoM
- Both lowest and median require a 3X to 5X acceleration of monthly inflation in December
See what we mean? Unless inflation massively accelerated in December, inflation is tracking way below what the Fed forecast.
- we believe this would necessitate a dovish adjustment to their inflation view when they hold their February FOMC.
COMMODITIES: Leading indicator of headline inflation and points to near stoppage of inflation
On the first trading day of 2023, commodities are already soft:
- natural gas (NG1 Comdty <<GO>>) down -10.5% to $4.008
- crude (CL1 Comdty <<GO>>) down -4.1% to $76.92
- even Wheat is down -2%
Look at the past year in these 3 key commodities. They are essentially at the same price seen at the start of 2022:
- zero inflation in oil, natural gas and wheat
- doesn’t this suggest this is 0% inflation working its way through goods and services?
Similarly, take a look at some recent European inflation readings for December.
- see the “negative” inflation aka deflation?
- so the softer inflation theme is also seen in Europe
STRATEGY: If FCI eases, S&P 500 could surge double-digits, led by Discretionary
There are 5 components to the GS FCI (see below):
- Fed funds
- 10-yr yields
- BBB spreads (investment grade)
- S&P 500
- TWI, or trade-weighted dollar
Thus, easing of FCI is really:
- 10-yr yields –> yields fall
- BBB spreads (investment grade) –> spreads rally
- S&P 500 –> equities up
- TWI, or trade-weighted dollar –> dollar weakens
SECTOR: Industrials, Discretionary, and Technology most levered to easing of FCIs
Naturally, if one wanted to maximize positive exposure to easing FCIs, we should look for sectors that best respond to the above changes (yields, spreads, dollar). Our data science team compiled sectors most levered to easing FCIs.
The correlation is shown below (highest value most important):
- correlation to FCI based on weekly % change, past 10 years
- most levered (OW): Industrials (XLI 0.98% ), Discretionary (XLY 1.53% ) and Technology (XLK 1.35% )
- least levered (sort of UW): Energy (XLE 0.32% ) but this isn’t really negative to FCI
- The “least” is not necessarily outright underweight, but rather least benefitting
POST-2022: Skew is for a double-digit 2023
Recall also that stocks rarely post two consecutive annual declines. And as shown below, 3 of the top 5 best ever gains were seen in years after a decline.
I also found this tweet by @RyanDetrick interesting. He notes that 27% of all years for S&P 500 are gains >20%.
- so while investors are “biding their time” (understandably)
- the skew is for stocks to post double-digit gains
- we think easing of FCI will be key, but we expect such if next few inflation readings are soft
SENTIMENT: BofA Sell-side indicator points to 20%-gains in 2023
One of our strategists, Alexa Sinsheimer, passed along the following piece by BofA. Their sell-side indicator fell to 53:
- at 53, the S&P 500 forward return is positive 95% of the time
- median gain is ~20%
- so, you can see the odds favor a larger than expected (vs consensus) move in equities
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