The period since equity markets and Treasurys retreated in March 2022 has been marked by a combination of gloom and confusion, with plenty of talk about a looming recession triggered by Fed rate hikes, but resilient economic data generating a strange air of disbelief.
This is being reflected in commentary from the real economy. On Friday December 9 Bank of America CEO Brian Moynihan told CNBC "American consumers are spending more this year than they did last year. In fact, in the first week of December, it picked up a little bit from November to a little higher percentage say 6% versus 5%. But it’s still strong and it’s consistent with a 2% plus growth economy."
The jury is still out on the likely duration and depth of an anticipated growth slowdown, and how it will impact monetary policy. From our perspective the lack of clarity is the result of the long, fading, tail of post-Covid recovery, and stimulus-buoyed savings accounts, rather than anything to become contrarian about.
The data is unequivocal that a slowdown is coming, with inflation still elevated, earnings revised lower and lower, freight rates collapsing, and even the crude oil price has stalled below $80 a barrel despite ongoing geopolitical tension.
Isn’t this already priced-in to equities? We don’t think so. The October and November 2022 rally was based on divining dovish signals from clear Fed guidance that policy rates will continue to be raised, and a downward correction in the dollar. That isn’t a foundation for a sustained equity uptrend so we expect the market to test its 2022 lows in 2023.
It's always darkest before the dawn
Another leg down in equity markets when the recession actually manifests itself, and the Fed’s terminal policy rate is confirmed, will be difficult for the real economy. This is the time though when investors must act and rebuild growth-oriented equity positions, particularly if, as many expect, the recession is mild in the US. In addition, the Fed’s tough talk through this tightening cycle will face its ultimate test when recession arrives. If the Fed pivots with inflation well above its 2% target, which is possible, that will be a strong signal to get out of cash and back into financial assets whether they be bonds or equities. In that scenario a 2020-like melt-up in equity markets cannot be ruled out.
Figure 1: US CPI still a long way from 2%
Source: S&P Dow Jones Indices, Robeco
Furthermore, even if the Fed holds its nerve, there are other obvious catalysts that could manifest in 2023. First, if the recession is mild – the fabled soft landing – and earnings projections stabilize, equity investors will conclude the bottom is already in and rebuild positions accordingly.
Second, any ceasefire, or more improbably a peace deal, in the Russia-Ukraine conflict would simultaneously reduce inflationary pressure, release pressure on central bankers and buoy risk appetite. This rosy scenario appears highly unlikely now, but so did war in late 2021.
Third, China’s recovery from Covid is likely to crank into gear after its recent relaxation of pandemic restrictions. Even for China skeptics the impact of a simultaneous recovery in domestic consumption, infrastructure investment and property market stabilization will have a dramatic effect on growth, especially in Asia Pacific.