1.4 trillion dollars is a lot!

There sure seems to be a lot to worry about. Inflation, recession and a tough-talking Fed to start. Also, via the Institutional Strategist, fading dollar strength, the separating of East from West in terms of trade, governance styles, capital flows, war, the Mideast where the Saudis have shifted their view of the future, the risk of a major cyber event, a debt/derivatives bulge around the world that markets are just starting to price…. Whew! Bears are warning the worst is yet come as the full effects of Fed rate hikes (with more on their way as the December minutes made clear) have yet to be felt. Earnings almost certainly haven’t fully adjusted. Outside of the Energy sector, estimates for 2023 have dropped by 12.5%—about half the average 24% decline during recessions, which consensus expects this year. Margin compression almost certainly has more to go. It peaked at 16.2% in Q4 2021 but, through Q3 2022, had only come in 1.3 percentage points to 14.9%. Still, the S&P declined 19% last year. Yardeni Group thinks markets already have discounted much of the tightening and notes most asset bubbles, especially crypto, burst without much collateral damage. U.S. markets also continue to benefit from record foreign capital inflows. With sentiment still extremely bearish, rhetoric too, such a mixed picture suggests a wide trading range this year, complete with a retest of last year’s lows.

This bear market certainly is unique relative to others over the last 40-years, with a simultaneous bond bear market making stocks less attractive from a valuation perspective. Past bear markets have been met with lower yields, creating a value proposition for equities. That’s not the case today. Renaissance Macro believes this dynamic will continue unless/until bond yields fall meaningfully. That arguably would require a recession. Even without one, government bonds are starting to look interesting. Their coupons represent attractive income and, with inflation starting to roll over (more below), upward pressure on yields is fading. It may be early as futures are pricing another 100 basis points or so of Fed tightening. But bonds already have undergone a dramatic repricing. Indeed, since peaking above $17 trillion in Q1 2020, the amount of negative-yielding bonds globally has evaporated. The credit end of the bond market is dicier. There are good reasons to like EM bonds (more below). But similar to equities, investment grade and high yield, which have seen spreads remain relatively subdued (partly on decelerating new issuance), face earnings challenges. So, credit spreads are more likely to widen than contract in the months ahead, making for a mixed picture for bonds.

After Santa was a no-show, today’s rally on favorable wage growth news (more below) was a welcome change. With retail traders selling $3.1 billion in the past week (year-end tax-loss selling was a major factor), there was some near-term technical pressure for a move up. Whether it has staying power is less certain. This market has been marked by upswings followed by downdrafts, with overall levels remaining range-bound in a bearish stupor. The broad markets are still far from meaningfully oversold conditions, and the Nasdaq 100 looks poised to retest its October 2022 lows. A break below those lows puts pre-pandemic highs in play at the next level of support. For now, the defensive/value play still seems to be the place to be in equities. Dividends increased 10.3% year-over-year (y/y) in Q4, a sign CEOs remain optimistic enough to increase payouts even as a majority expect a recession. As for the consumer, slowing job growth, expiring Covid-era programs and a rising savings rate that typically accompanies recessions may pose headwinds for consumer spending this year. Drawdowns of stimulus-fed savings accounted for 75% of 2022’s growth in consumer spending, which represents nearly 70% of GDP. That said, households are still sitting on an estimated $1.4 trillion of pandemic savings, bank deposits are flush with cash and slowing job growth is still above trend. This could ease a lot of worries … $1.4 trillion is a lot.

Positives

• Soft landing? December’s 223K increase in nonfarm jobs and drop in the jobless rate to a 50-year low 3.5% mildly surprised to the upside. But underlying data continued the trend toward normalization, with the workweek declining to near pre-Covid levels, growth in aggregate hours—the broadest measure of private sector labor input—falling to a 1.1% annualized pace (vs. a brisk 4.8% in 2021) and average hourly earnings rising at their slowest pace since August of 2021. With revisions to past months, nominal wage growth is now running near 4%, close to the 3.5% pace consistent with 2% inflation.
• This is what disinflation looks like December manufacturers’ prices plunged in S&P Global and ISM surveys, the latter to the bottom decile of readings going back 75 years. Natural gas and crude oil prices have plummeted, the former to mid-summer 2021 levels (on the warmest start to a year in more than 15 years and Europe’s rush to wean itself off Russian supply) and the latter to December 2021 levels. Elsewhere, the Atlanta Fed’s sticky ex-shelter core CPI measure rose at just a 2.2% annualized rate in November, down from a 9.5% peak and on a 3-month basis is back to where it was in late-2021. Also, consumers’ forward inflation expectations slid sharply in the latest Michigan and New York Fed surveys.
• An environment for active management Nearly half of U.S. large-cap active funds outperformed their respective Russell benchmarks in 2022, their best year since 2017 and well above the 36% average outperformance since 2003, Bank of America reports. It says 58% of stocks outperformed benchmarks that were top heavy with mega-cap Tech laggards, with the five largest S&P companies still making up 19% of the index, higher than the Tech Bubble peak of 18%.  All in all, a stock picker’s environment.

Negatives

• Services plunge into year-end December’s services ISM and PMI gauges contracted much more than expected, though there were good reasons to think transitory considerations played role. These include a cold snap that hit much of the country in the second half of December and likely hangover effects from a strong November. Indeed, December’s 10-point decline in business activity came on the heels of a 9-spike the prior month. Still, it was only the second time in the history of the ISM survey that new orders fell more than 10 points in a month’ the other instance was April 2020, during the Covid lockdowns.
• Manufacturing limps into year-end December’s ISM and PMI manufacturing readings plunged deeper into contraction as new orders in both surveys fell at one of their fastest rates ever. The drop-off coincided with falling consumer demand for goods. In fact, holiday spending on goods fell 3.4% y/y the past two months, credit card data show, even as overall spending rose on outlays to restaurants, travel and other experiences, pushing services’ share of spending to 2019 levels.
• Housing continued to sink into year-end Spending on single-family homes fell 4% in real terms in November and 23.4% y/y, a sign the market is struggling to find a bottom amid falling mortgage rates and declining home prices in many metro areas.

What else

Not your parent’s EM Used to be when our economy slowed, emerging markets tanked. Now, with U.S. recession risks rising, markets see prospects for sustained Asia/EM outperformance this year for the first time since 2010. Among favorable factors: superior relative valuations, better earnings prospects and a reopening China, where the government lifted its zero-Covid policy last month. The virus, which is spreading like wildfire through cities, is expected to soon peak on rising vaccinations and herd immunity.

Energy isn’t done The sharp drop in energy prices off 2022’s peaks could make for a more volatile year for Energy, last year’s runaway winner. Its 59% return helped double its S&P sector weight the past two years. But with domestic producers curbing capex and the Saudis/OPEC+ committed to a floor, a price rebound is possible as soon as February-March, a strong seasonal buying period.

Drone on Walmart was on target to expand its 2-year-old drone delivery service to 34 stores in 23 cities by the end of last year and aims to deliver more than 1 million packages by drone each year. Its drones can deliver items as delicate as eggs and weighing up to 10 pounds in as little as 30 minutes for a $3.99 fee. On a different front (literally), Ukrainian forces are using a Turkish drone the size of a small plane to identify enemy targets and guide missiles toward them, eliminating the need to send special forces.

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