After one of the worst years ever for investors in 2022, we are quite happy to report that 2023 is off to a much better start. The S&P 500 is already up more than 4% for the year and flirting with the round number of 4,000. Optimism that the economy can avoid a recession (more below) and clear signs that inflation has peaked, thus forcing the Fed’s hand on continued interest rate hikes, have led to a great first half of the first month of the year.
- 2023 is off to a great start for stocks, a welcome change from 2022.
- Many are calling for a recession in 2023, but there are clues they could be wrong.
- Various parts of the economy are still growing while the consumer remains quite healthy.
- Inflation continues to fall and likely will fall quicker than most expect.
China potentially reopening has sparked strong buying in various industrial metals, specifically copper. Copper is reaching new monthly highs, and we don’t think this would be happening if a large global slowdown was coming. Historically, copper has been a good gauge for the global economy, and its strength is yet another clue the situation is different (and better) than 2022.
Lastly, strength in the first month of a pre-election year is nothing new. In fact, January is typically the best month in a pre-election year, up a very solid 4.1% on average. The first few months of a pre-election year also tend to be strong based on seasonality, which investors should be open to yet again.
Why is Everyone Predicting a Recession?
Most outlooks are forecasting a recession in 2023. In contrast, we on the Carson Investment Research Team believe the economy can avoid a recession this year.
The recession calls are all predictions and clearly not reflections of where the economy is right now. The NBER’s preferred list of economic indicators, which is used to determine a recession, shows every single indicator grew over the past three months and year-to-date (2022). In fact, four out of the six indicators have exceeded their pre-pandemic growth rates over the past three months (comparing the yellow bars against the dark blue bars).
Of course, this is 2022 data and the question is what will happen in 2023. So far this year, inflation has fallen, and with relatively strong wage growth that means higher real incomes. Lower gas prices, lower energy prices (utilities), and lower food prices mean consumers will have more money in their pockets. Just as higher inflation is effectively a tax on income, falling prices are akin to a tax cut. And unless households choose to save this excess income, consumption will stay up.
In addition, 38 states have significant tax changes that took effect Jan. 1. As the Tax Foundation notes, most represent net tax reductions, which are the result of a wave of tax cuts over the past two years as state revenues surged and governors/legislatures looked to ease the impact of higher prices on residents.
Also, Social Security recipients are slated to receive a cost-of-living adjustment of 8.7% to their incomes in 2023, a function of last year’s high inflation but coming just as inflation starts to pull back. Seniors will get another break from Medicare premiums, which are slated to fall this year.
These are all tailwinds for consumption, which makes up 70% of the economy.
So, Why the Recession Calls?
In short, forecasters are expecting the Fed’s aggressive rate hikes of 2022 to hit the economy in mid-2023 and beyond. The idea is that monetary policy impacts the economy with “long and variable lags,” as Milton Friedman said. Even Fed Chair Jerome Powell and other Fed officials have cited the uncertainty around the lagged impact of their rate hikes as a reason for stepping down the pace in December. They want to wait to see the impact of the 425 bps of rate hikes they implemented last year.
However, the reality is monetary policy impacts the economy through financial conditions. Higher interest rates can crimp household demand for mortgages, and tighter credit conditions can curb business spending, including hiring, capital expenditures, and mergers and acquisitions.
In fact, because of the Fed’s forward guidance and other commentary (including leaks to the press), financial conditions can tighten well in advance of actual rate hikes, as investors anticipate future Fed actions. The chart below illustrates this point. Across 2022, financial conditions tightened well ahead of the Fed’s rate hikes.
This means financial conditions can impact the economy sooner than most people expect. The steep falloff in housing activity is a good example of how tighter financial conditions can be felt almost immediately. Residential investment has been a significant drag on GDP growth since the second quarter of 2022, which is when financial conditions started to really tighten in anticipation of the Fed’s aggressive turn. On an annualized basis, residential investment fell 18% in the second quarter of 2022 and 27% in the third.
So, we may be beyond peak negative impact of rate hikes on the economy. Most of the tightening in financial conditions occurred during the first three quarters of 2022. In fact, financial conditions have eased since October (coinciding with a stock market rally). That is even more positive for economic growth, as the drag from tight financial conditions declines.
Good News on the Inflation Front
We now have a trend! Headline inflation fell 0.1% in December, the slowest pace since May 2020. Inflation has now decelerated to 6.5% year-over-year, quite a pullback from the 9.1% level six months ago.
As the chart shows, the big driver has been falling energy prices. In fact, gas prices at the pump fell 9.4% in December and are 1.5% lower than a year ago. Even better news is inflation is falling more broadly now.
- Food inflation continues to decelerate, rising just 0.3% in December, the slowest pace since March 2021.
- Core goods prices, excluding food and energy, fell 0.3% in December, the third consecutive month of price declines.
- A big factor was used car prices, which fell 2.5% in December and are almost 9% lower than a year ago.
- New vehicle prices fell 0.1%, the first monthly decline in two years and a welcome one.
- Pandemic-impacted services, such as vehicle rentals and airfares, are also seeing less price pressures now.
- Housing is keeping pressure on prices. But housing inflation looks to have peaked, and the deceleration in market rents will be reflected in official data eventually.
The Fed will eventually have to acknowledge that price pressures are easing in a broad way, with the obvious implication that they need not maintain policy at such a restrictive level. This is what investors, at least in the bond market, are currently betting will happen, with rate cuts priced for the back half of 2023.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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