Wait and See: Quarterly Economic Report

The year is coming to an end in an atmosphere of anticipation. Will inflation slow? Will the labor market decline further? Will there be a recession? What will the Fed do?

High inflation, rising interest rates, and recession fears have made for a rough financial ride in 2022, with falling stock and bond prices pummeling portfolios for much of the year. Stocks may have rallied this quarter as inflation has started to moderate, but questions over the Federal Reserve’s actions on interest rates continue to generate economic uncertainty.

Equity markets did well in the last couple of weeks. Investors priced in a divided government following the midterm elections, in which the Republicans gained a fractious, narrow majority in the House, while the Democrats took greater control of the Senate.

Politics matter. But inflation, central bank policy, and the resulting impact on economic growth are even more consequential factors. We expect them to be the primary determinants of performance going forward.

How Big a Rate Hike?

All eyes are on the Fed, and the future pace of interest-rate hikes. The release of the minutes of the November 2022 meeting of the Federal Open Market Committee (FOMC) gave investors more detail on the discussions that took place.

Early in the minutes, the FOMC addressed what has become the most important question for the market: is the current pace of 75-basis-point rate hikes at each meeting going to be sustained? The answer was “most likely not,” given the cumulative magnitude of previous rate hikes. If the inflation data cooperates, the 75-basis-point increase approved at the November meeting may be the last super-sized hike.

That said, the path back to 25-basis-point hikes may be slow. Investors should anticipate a step down to a 50-basis-point hike at the next FOMC meeting in December, followed by a pair of 25-basis-point hikes at the January and March meetings, with the ultimate rate topping out at 5%.

During his November 2022 speech at the Brookings Institution in Washington, D.C., Fed chair Jerome Powell gave further hints about the direction interest rates are heading. Powell stated then that the pace of rate hikes will likely slow in December, but he also warned that the inflation fight is far from over and policy should remain restrictive for some time.

Powell added that “ongoing increases will be appropriate” and that what matters most is the level rates will ultimately rise to and how long they remain elevated, rather than the rate of change. In October, the Fed’s favorite inflation index–the Bureau of Economic Analysis’s Core Personal Consumption Expenditures Index–indicated that price increases may be stabilizing. However, inflation and employment data have yet to reflect the Fed’s desired outcomes.

Even though the Fed has hinted at a slowdown in the pace of interest-rate hikes, the central bank’s analysis will be driven by the data, and whether the central bank’s aggressive monetary policy is having the desired impact on economic activity and inflation.

Jobs, Jobs, Jobs

Stocks initially dropped in early December due to a stronger-than-expected U.S. jobs report that appeared to call into question whether the Fed will begin to slow the pace of interest rate hikes later this month. Though the report showed stronger employment rates than anticipated, it still showed a jobs slowdown. The U.S. economy added 263,000 new jobs in November, below the three-month average of 282,000 and significantly lower than the 2022 monthly average of 392,000 jobs.

A relatively continuous and consistent set of data from freight rates to used car prices points to cooling inflation on the goods side of the economy. However, consumer spending on services continues to put pressure on those prices, which are much more sensitive to wage growth. Strong labor income will continue to support this kind of spending.

With many economists and CEOs forecasting a recession in 2023, we anticipate some corporate belt-tightening, which could be the catalyst for a slowdown in the jobs market and in wages.

Despite some signs of economic weakness, employers are reluctant to reduce hiring because of the difficulty they have had finding workers in the wake of the COVID-19 pandemic. That reluctance may keep the jobs market tighter than economic models suggest under an economic slowdown or even a mild recession.

We agree with the Fed’s assessment that there are nascent signs of the jobs market coming into better balance. A better-balanced labor market will be critical to tamping down inflationary pressures, especially as those pressures are manifesting in the labor-intensive services sectors where there appears to be elevated household demand. Key labor market fundamentals—such as underlying growth in the labor force and recent trends in the labor force participation rate—suggest that the pace of job gains will slow in 2023.

As of November 2022, 1.3 million people had left the workforce after turning 64. Another 630,000 people didn’t wait to hit that age before quitting. “The effect of this demographic shift on participation won’t reverse without massive structural changes in workforce behavior over time,” said a quartet of analysts (Jean Boivin, Wei Li, Alex Brazier, and Nicholas Fawcett) from the New York investment firm BlackRock in a report on November 28, 2022. “That implies the workforce will keep shrinking relative to the population. Economic activity will need to run at a lower level to avoid persistent wage and price inflation, especially in the labor-heavy services sector.”

Inflation Odds

Since the Fed meeting in early November, five-year inflation breakeven expectations have fallen from 2.54% to 2.34%. Through November of 2022, the all-items Consumer Price Index (CPI) increased at an annual rate of 7.1%, while the core CPI—which excludes food and energy prices—increased at an annual rate of 6.0%. Market participants believe that ultimately inflation will fall toward the Fed’s 2% target but may not quite get there; certainly, few believe that today’s extremely elevated rate will persist well into the future.

Lifting interest rates is one of the primary ways the Fed can cool the economy. When rates go up, it becomes more expensive for businesses and individuals to borrow money. That can hurt future growth, thus bringing demand and supply in line with each other.   That strategy is inflicting pain—and risks recession—for consumers and investors who have enjoyed more than a decade of cheap money to buy houses, cars, and other assets such as stocks and cryptocurrency.

Brewing global tensions are also playing a part as the Russia-Ukraine conflict continues and, tensions with China over Taiwan escalate. Cyclical acceleration in demographic and geopolitical trends, rapid monetary tightening, and the Chinese slowdown exacerbating supply-chain and pricing pressures all suggest a more challenging economic environment. We expect an economic slowdown in 2023. However, households, businesses, and financial institutions overall are in better shape to handle this than in other recent downturns.

S&P earnings estimates for 2023 have been coming down since the summer. We continue to expect an economic slowdown next year. While investors are realistic enough to discount some additional slowing, it’s not clear whether earnings estimates reflect a full-blown recession.

Cautious commentary from financial journalists and analysts on the economic outlook has been disappointing for many companies, especially the big tech names: Google anticipates more weakness given the poor advertising outlook; Microsoft sees weakness based on the Cloud outlook; and Meta, as well as Amazon, are guiding analysts to reduce expectations going forward. For Amazon, the prospect of an underwhelming holiday spending season sent investors fleeing and drove the stock down to a pre-pandemic price level, despite actual revenues being more than 80% higher than in 2019.

The U.S. central bank is looking for more consistent evidence that inflation will fall toward the 2% target reliably over time, and the data on that front remains inconsistent. The pace of economic activity has been uneven this year. After declining at annual rates of 1.6% and 0.6% in the first quarter and second quarter of 2022, respectively, U.S. real gross domestic product (GDP) increased at a stronger-than-expected 2.6% annual rate in the third quarter. Growth in the third quarter was unusually brisk because of a large contribution from real net exports—the largest in 42 years. However, the boost from net exports is likely to reverse over the near term because the Fed’s real broad dollar index, a trade-weighted measure of the dollar against a basket of currencies, was at a 37-year high in October 2022, and global economic growth, particularly in Europe and China, is weakening.

Accordingly, the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters (SPF) in November projected that real GDP would increase at a 1% annual rate in the fourth quarter of 2022. If this growth is realized, real GDP would increase by 0.8% over the four quarters ending in the fourth quarter of 2022, far below last year’s 5.7% growth rate and well under the economy’s trend growth rate of about 2%.

The SPF projects that GDP growth will remain positive in 2023, with an increase of real GDP of 0.8% and an unemployment rate that will average 4.2%. The Fed’s commitment to restore price stability, while necessary, could cause the economy to slow further next year. Indeed, a recession is not out of the question.

Conclusion: Darkest Before Dawn

In general, the years in which stocks did well after the final interest-rate hike were marked by a strong labor market, while poorer performances were associated with a subsequent contraction in payrolls. As such, the labor market is likely key to market performance once the Fed pauses. All else being equal, we expect volatility and bouts of weakness to persist heading into 2023 alongside a weakening in the labor market, but a sunnier environment as the pages of the calendar turn toward the second half.

Our expectation of more near-term volatility to come is supported by likely worsening trends in corporate earnings. We expect at least a quarter or two of negative year-over-year earnings, even including the energy sector, before a stabilization is possible. But we also expect a rolling hit to earnings at the sector level, in keeping with the rolling recession ongoing in the economy.

It may seem counterintuitive, but weakness in both corporate earnings and the labor market would be welcome sooner rather than later, as it would bring the Fed closer to checking the box of increasing slack in the labor market and ultimately help put downward pressure on inflation. If that occurred alongside a stabilization or higher turn in leading indicators, the economy would be set up for better days later in the year.

At least until the economy begins to stabilize, we recommend that investors focus on quality-based factors, including balance-sheet liquidity, positive earnings revisions, strong free cash flow, dividend growers, and lower volatility. There may be a time in 2023 to move down the “quality spectrum” to take advantage of an upturn in growth, but that would likely be later in the year. In the meantime, as the market continues to try to time a shift in policy by the Fed, factor volatility could remain elevated.

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