Mixed messages

A great week to be back in Pittsburgh and visit with sales and research colleagues. We discussed crosscurrents in the economy and markets and how to navigate them. Takeaways: in equities, 2023 is a year “to be humble.” There are doubts the strong start to the year is sustainable. Similar worries for bonds, which also roared out of the gate. Our strategists are looking “to be more tactical than strategic.” Conviction is hard when there are so many mixed messages. Powell, for example, this week reiterated policymakers’ work is not done (hawkish) but was reluctant to lean against easing financial conditions (dovish). He also said the Fed’s prepared to raise rates another quarter point at each of the next two meetings (hawkish) but opened the door for rate cuts later (dovish). Disinflation signs abound—chicken wings, eggs, guacamole and auto prices are falling fast, as are rents and truck hauling rates, and manufacturing activity is contracting (more below). In fact, Powell cited “disinflation” 13 times at his press conference vs. zero times after December’s meeting. Yet January’s payroll gains were eye-popping (more below), and services activity rebounded sharply off December’s 2.5-year low (more below). Powell said he’s yet to see evidence that non-housing services inflation, which reflects wages and accounts for more than half of core PCE, was easing. My head is spinning.

Stocks and bonds appear to be in a “sweet spot,’’ historically observed between an inflation problem and subsequent recession. Deutsche Bank notes the most widely used measure of U.S. bond volatility dropped this week to a 10-month low, and the stocks-centric VIX neared a 13-month low. The more robust markets are in the near term, the more likely the soft-landing narrative that Powell again mentioned may take over. Whether the narrative holds is a different matter. Markets in many ways are just returning to where they normally would be a year into an average hiking cycle. Cracks typically don’t emerge until the second year on. The Fed didn’t start hiking until last March. Even if peak rates are reached by spring, tailwinds that fueled a late-autumn/early-winter growth spurt (excess liquidity from corporate and Covid-related consumer savings, higher real incomes, a surprisingly fast reopening China) are fading. Credit Suisse believes the impact (lower volatility, tighter credit spreads and re-rating higher of P/E multiples) from these positive catalysts have largely played out. This limits the potential upside to what many on Wall Street are calling a “junk rally,” with high-beta and meme stocks, lower-quality credits and bitcoin leading value and cyclical names by a wide margin, a flip-flop from 2022. Hedge fund short covering is behind a lot of the activity—the highest since November ’15, even exceeding January ’21’s meme frenzy. FOMO (fear of missing out) is rampant, with 59% of Russell 3000 names making 20-day highs. Mixed messages everywhere.

There is something unusual about chasing risk when the yield curve is so inverted, money supply is contracting for the first time in at least 60 years and labor force participation is hovering at mid-’70s’ lows. Yet semiconductor and consumer discretionary names keep climbing, new highs are expanding, FOMO investors are quickly leaving defensive names and, in bond land, the 2-year Treasury yield is trading nearly 50 basis points below the federal funds target rate. It seems neither stocks nor bonds believe the Fed. Strategas Research says the next level of any meaningful significance above 4,150 on the S&P 500 is 4,325 (the August highs). After living in a macro market for the last three years (Covid, inflation, Fed), Bank of America sees crosscurrents complicating the typical market cycle playbook and wonders when bad macro data will lead to bad markets? When bad macro data translates into bad earnings and higher credit risks, perhaps? In all my years, “Don’t fight the Fed” has proven to be wise advice. So, are you a trader or an investor? Either way, so many mixed messages call for being “perched” for fat pitches. EM bonds, small-cap value stocks and European equities look cheap now. FOMO is for traders. For investors with a 3- to 5-year view, we see slower growth, stubbornly higher inflation (around 3%) and a Fed that keeps policy rates higher for longer. “This is not like other business cycles in so many ways,” Powell said. You can say that again.

Positives

• Goldilocks January’s 517K payroll gains, the largest since July and almost triple consensus, and a larger 866K jump in the separate survey of household dropped the jobless rate to 3.4%, a 53-year low. Seasonal and population adjustments were factors (more below). But the underlying data reflected a very strong labor market nearly a year into Fed tightening. Despite the surge, average hourly earnings grew at 4.4% year-over-year, the least since August 2021 and a sign that gains were centered in lower-paying services where workers’ propensity to consume is high—a positive for the economy.
• Good news is good news In another sign of moderating wages, the Employment Cost Index decelerated a third straight quarter to a 4% annual rate in Q4. Services wages (which the Fed is watching closely) rose at a 4.1% rate in ’22’s final three months, well below its 7% peak. Though a tough year, productivity improved strongly in Q4, hopefully the beginning of a trend.
• Good news may be bad news January ISM services unexpectedly jumped to 55.2 after contracting in December, blowing through consensus at 50.4 on higher business activity/production, order backlogs and new orders. Employment held steady as some respondents reported difficulty finding workers. The report could feed Fed concerns about non-housing services, a major component of core PCE.

Negatives

• Manufacturing slump deepens January’s ISM fell to its lowest level since 2009 and below the depths of the Covid contraction amid a deepening pullback in domestic goods demand. New orders fell to lockdown lows, and only two of the 18 manufacturing industries reported increases in activity. On the other hand, employment remained expansionary as companies held onto workers.
• Mixed messages Stripped of often-criticized seasonal adjustments, January nonfarm jobs would have fallen 2.5 million, TrendMacro says, and household employment would have risen only 84K if left unadjusted for population changes. At +106K, a 2-year low, ADP payrolls disappointed and Indeed.com and other private-sector measures showed job openings continuing to decline. Also, December’s quits rate fell and the gap between initial and continuing jobless claims remained wide, suggesting newly laid-off workers face struggles securing new jobs.
• Consumers didn’t get the jobs message January Conference Board confidence fell below December’s surprise gain as consumers’ outlook for income, business and labor market conditions weakened. The expectations component was below 80, historically a signal for recession within the next 12 months.

What else

EVs starting to make an impact? Americans are driving more on less gasoline, somewhat easing the sting of last year’s spike in prices. The U.S. Energy Information Administration reports American drivers used 10K barrels/day less gasoline through 2022’s first 11 months than in the year-ago period, and 540K barrels/day less than in 2019, even though Americans collectively traveled more last year than in 2021 and drove a similar number of miles as in 2019.

If only pets could work Japan, which confronts a shrinking working-age population problem that is worsening, now has more pets than children under the age of 16.

Does “revenge spend” not translate? The Chinese consumer is not like we are, coming out of the gate, spending everywhere. Indeed, while their surge in cash holdings has captured the attention of markets and helped underpin bullishness about growth, the evidence indicates the recent increase mostly came from a shift in the allocation of financial assets, with cash more likely to flow into those assets than to juice extra consumption.

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