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What a difference a year makes!

December 19, 2022
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What a difference a year makes! 

One year ago the Federal Reserve was forecasting that real GDP would grow a strong 4.0% in 2022, that PCE prices would be up a relatively moderate 2.6%, and we should expect a grand total of three 25 basis point (bp) rate hikes by the end of the year.

Instead, it looks like real GDP will be up about 0.5%, PCE prices will be up 5.6%, and we had the equivalent of seventeen 25 bp Fed rate hikes, finishing the year at 4.375%.  So, if you feel a little dizzy about all of this, imagine how the Fed feels.

For 2023, the Fed is forecasting another year of 0.5% real GDP growth, inflation of 3.1%, and the unemployment rate rising to 4.6%.  As for Fed policy, the dot plot shows another 75 bps of rate hikes in 2023, and no planned cuts.

I think growth will undershoot the Fed’s forecast in 2023.  Instead of growing 0.5% in 2023, we expect real GDP will shrink about 0.5%.  Meanwhile, I think inflation will overshoot: ending next year above 4.0%.  Sure, inflation moderates in 2023, but not as much or as fast as many expect.

What does that mean for the Fed?  While others obsess about short-term interest rates, we still think investors (and the Fed) should pay more attention to the money supply, M2 in particular.  M2 surged in 2020-21, hitting a peak of 27% year-over-year growth and rising a cumulative 40%.  But in the past year, M2 growth hit a wall, and is up just 1% from a year ago.  If accurate, this means economic activity is likely to slow very sharply – and soon.

Lurking in the background of all these forecasts, including our own, is the fact that we are in unprecedented times.  Forget COVID lockdowns; every prior episode of inflation in the post-World War II era was accompanied by the Fed operating in a “scarce reserve” system, whereby it would tighten monetary policy by draining reserves from the banking system to make short-term interest rates move higher.  Meanwhile, those reserves would generate zero income for the banks unless they lent them to other banks.

Now, for the very first time with high inflation, the Fed is operating in an “abundant reserve” system, trying to tighten monetary policy by directly paying banks higher interest rates to hold the copious reserves that well exceed banks’ needs.  The continued growth in bank credit suggests that, so far, this experiment in monetary policy is not quite going according to plan.

Put it all together and the only thing we’re confident about is that whatever happens in 2023, it will likely look very different from what the Fed is forecasting.  

 

That being said, let’s look at what a few people say about their forcast for 2023:

 

Let’s start with Fundstrat: The bond market is starting to call the Federal Reserve's bluff that it will still be hiking interest rates in 2023, according to a Friday note from Fundstrat, and that's good news for the stock market.

The note highlighted how the 2-year US Treasury yield has a knack for sniffing out where the Fed Funds Rate will most likely land going forward, as it did in January of this year when the 2-year yield yield quickly rose to about 1% while the Fed Funds rate remained near zero.

Even Jeff Gundlach of DoubleLine Capital has said the Fed could be replaced by the 2-year Treasury yield, as all the Fed does is follow what the 2-year yield does. 

Fed chairman Jerome Powell has been playing catch-up with interest rate hikes until today, as the 2-year Treasury yield is finally below the current Fed Fund's rate.

At this week's FOMC meeting, the Fed projected a 2023 year-end Fed Funds rate of 5.1%, suggesting three more interest rate hikes of 25 basis points next year. But the 2-year US Treasury yield has been on the decline since it peaked near 4.75% in early November, falling to about 4.25% today. 

That's below the current Fed Funds rate of 4.38%, and it means the Fed is either going to pause its interest rate hikes from here or even cut them, according to Fundstrat.

"In 2022, the bond market called the Fed actions well ahead of the Fed. And if this carries into 2023, the bond market says the Fed will soon turn dovish. That is good news for equities," Fundstrat's Tom Lee said.

 

Now let’s look at Barrons recent article: For U.S. investors, 2023 could seem like two years wrapped in one, with the stock market first falling in anticipation of a recession, only to rebound as the outlook improves toward 2024. The one constant: The Federal Reserve will call the shots, much as it did this year, as it strives to curb rampant inflation and restore price stability.

Stocks could continue sliding as 2023 unfolds, particularly if the Fed’s interest-rate hikes push the economy into a recession. Then again, a more modest economic slowdown might be enough to reduce price growth to a level near the central bank’s annual target of 2%.

Once the Fed pauses its tightening, the gloom shrouding Wall Street could lift, setting the stage for a stock market rally. Based on the average of the predictions of eight investment strategists recently canvassed by Barron’s, the S&P 500 could end 2023 at 4233, 9% above its current level.

Despite the most rapid tightening of financial conditions in a generation, and the turmoil in financial markets, the U.S. economy is entering 2023 in decent shape. Job growth remains robust, consumers have ample savings to support spending, and corporate earnings are at record levels. But a strong labor market, in particular, is keeping inflation uncomfortably high and the Fed on its tightening trajectory. 

Several strategists favor financial stocks, and U.S. banks in particular, especially if interest rates remain elevated and the economy skirts a deeper recession. Higher rates mean stronger near-term earnings and cash flow. Earnings-revision trends have been better in energy and financials than the overall market, says RBC’s Calvasina.

“Value is where you want to be in the near term,” she says. “You have compelling valuations in both financials and energy, with strong dividend yields.” (this is 50% of our new managed portfolio.)

Calvasina favors small-cap stocks over big-caps, due to their cheaper valuations and 2023 earnings estimates that, she believes, better reflect the potential for a recession. Small-caps are more domestically focused, which means they face fewer headwinds from a strong dollar. Also, investor positioning in small stocks is less crowded. (the other 50% of our portfolio is in small caps)

“Small-caps are pricing in a recession,” Calvasina says. “Price-to-earnings ratios are neutral to elevated [in the] S&P 500, with a lot of uncertainty on the earnings.” Small-caps historically have bottomed earlier than large-caps around a recession, she adds.

 

Finally Let’s see what Larry Summers, past Treasury Secretary has to say:

The economist flagged three things that could hit US activity at the same time: consumers exhausting their pandemic savings, businesses laying off workers after holding onto them in case of labor shortages, and corporate earnings slumping — which could also drag down stocks.

I agree with all three. All would have companies improving their productivity over the next 6 months. What that means is that any improvement in earnings would have a significant impact on profits once the Fed is done with tightening. In addition, I believe all of this will happen sooner than later which would mean the second half of next year should turn into a rally in stocks. Stay tuned as we watch the numbers going forward.


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