Holbrook Insights

Last week’s data was focused on inflation and the consumer, with the highlights coming on Thursday with the release of the CPI for December and the preliminary January University of Michigan consumer sentiment survey. Headline consumer prices fell 0.1 percent in December, and year-over-year consumer inflation moderated. This report indicates that tight monetary policy is working to help combat inflation, although there is still work to be done to get price growth back under control. Consumer sentiment improved more than expected to start January, supported by falling short-term inflation expectations that came in below estimates.

The future path of interest rates is uncertain for 2023, but the average Bloomberg surveyed economist expects to see another half percent of increases in the first quarter before levels remain stable through the second and third quarters. Last week’s release of December Consumer Price Index (CPI) data—coming down 0.1 percent, in line with expectations—showed that consumer prices continue to moderate. Signs of softening prices may bolster the case for the Federal Reserve (Fed) to reduce the size of its February 1 rate hike to 25 basis points (bps), but a 50 bps hike is still on the table. Market participants will be looking for signs that more convincingly point one way or the other. U.S. Treasury yields were down across the curve last week. The 2-year, 5-year, 10-year, and 30-year fell 9 bps (to 4.16 percent), 13 bps (to 3.27 percent), 8 bps (to 3.48 percent), and 7 bps (to 3.62 percent), respectively. 

The first week of 2023 was filled with economic updates. The holiday-shortened week saw releases kick off on Wednesday with the release of the ISM Manufacturing index and Federal Open Market Committee (FOMC) Meeting Minutes for December. Manufacturer confidence declined slightly more than expected in December, as slowing global demand for manufactured goods caused sentiment to drop. The minutes showed that many central bankers remain concerned about inflation despite the recent declines that we’ve seen in year-over-year price growth. The Fed is expected to keep monetary policy tight through the start of the year

The Federal Reserve (Fed) may feel that it has been receiving mixed signals recently as the labor market continues to show signs of tightness amidst softening inflation data. Regardless, Fed officials have yet to see convincing evidence that inflation is cooling at a sufficient pace, and we will likely see more rate hikes ahead. Bloomberg surveyed economists are anticipating another half percent of hikes in the first quarter of 2023. In addition to this coming Thursday’s release of December Consumer Price Index (CPI) data, markets will be keeping an eye out for comments from Fed officials that may provide a bit more insight on where rates could go from here. U.S. Treasury yields moved modestly last week. The 2-year was up 6 basis points (bps) to 4.49 percent while the 5-year, 10-year, and 30-year fell 6 bps (to 3.95 percent), 13 bps (to 3.75 percent), and 16 bps (to 3.81 percent), respectively. 

The last week of the year saw U.S. indices decline, while international indices such as the MSCI EAFE Index and Emerging Markets Index were up slightly. The Russell 2000 was also up slightly and many of these trends were indicative of those seen throughout 2022. The technology-focused Nasdaq Composite Index was among the hardest hit last year as the companies that scaled out quickly in the low interest rate environment following the great financial crisis and in 2020 saw those trends reverse in 2022. Companies such as Amazon (AMZN), Netflix (NFLX), Walt Disney (DIS), and Meta Platforms (META) were among the worst 15 contributors for the S&P 500 index in 2022. These names focused on scaling ahead of profitability in prior years. These names suffered as central banking policy became more aggressive, and the cost of capital rose amid high inflation in 2022. Amazon was focused on scaling its warehousing and ecommerce market share; Netflix scaled out subscribers and viewership, agnostic of who was paying for the service; Walt Disney launched its own Disney+ streaming platform to compete with Netflix; and Meta scaled its Metaverse concept, which continues to be a costly work in progress in achieving its vision for the future of online interaction. 

The Dow Jones Industrial Average, MSCI EAFE, and Russell 2000 fared better in 2022. The energy sector was just one of three positive sectors for the year, alongside utilities and consumer staples. That said, energy was the clear winner with the S&P 500 energy sector up more than 68 percent for the year versus just 2.16 and 0.42 percent in utilities and staples. Other sectors that held up a bit better included health care, industrials, financial, and materials. All three indices carry greater exposure to energy, utilities, staples, health care, industrials, and financials than the Nasdaq Composite. Consumer discretionary was also a major factor in 2022 as these S&P 500 sectors were down by 25.96 percent, 33.93 percent, and 38.56 percent, respectively. We look forward to 2023 to see if these trends will continue and if lower bars for sectors that were down in 2022 will set up easier comparisons in the second half of the year.  

In some ways, this concern is warranted. Looking back at 2022, we have seen China struggle with the economic impact of the Covid-19 pandemic. We have seen crypto companies in the U.S. implode. We have seen the Russia-Ukraine war continue. And, of course, we have seen inflation reach 40-year highs as both stocks and bonds moved into bear markets. We know the risks are real.When we look at the fundamentals for both the economy and the markets, however, things aren’t nearly as bad as headlines suggest. While we do face risks, the fundamentals are much stronger now than they were at the start of 2022. That should limit the risks and provide more opportunity in 2023.

If the economy continues to grow, however, those strong fundamentals could keep inflation higher and keep the Fed hiking, leading to a worse recession. Even though this is a possibility, it’s not what the data is indicating. Inflation appears to have peaked, with most of the components turning down, and that trend is likely to continue. While the Fed will probably keep hiking interest rates, the rate of increase—and the ultimate peak—will roll over even as inflation does. As 2022 ends, we see evidence of that in the inflation data, and also in the bond market, with the yield on the U.S. Treasury 10-year note peaking and rolling over. This likely reflects an impending slowdown but also indicates that interest rate damage may be peaking as well. All of that provides a good foundation for markets.

   Equities markets moved lower last week as the market continues to claw back against some moves from Fed Chairman Jerome Powell’s comments in November. Oil was hit hard last week, with West Texas Intermediate crude down 11.2 percent amid macroeconomic concerns. The market took a risk-off approach as utilities, health care, REITs and staples outperformed. Cyclicals such as energy, consumer discretionary, and financials were challenged amid concerns of a slowdown in 2023 as inflationary and economic data came in stronger than expected. Emerging markets bucked the trend as the China Covid-19 reopening trade remains in place.

 On Friday, the Producer Price Index for November was released alongside the December University of Michigan consumer sentiment survey. Producer prices increased slightly more than expected in November, but producer inflation declined on a year-over-year basis. The larger-than-expected rise in producer prices in November is a reminder that real work still needs to be done to get inflation under control. Consumer sentiment improved more than expected to start December, driven in part by falling short-term inflation expectations.

Equities markets continued to move higher as they also latched on to Powell’s comments for a slower pace of rate hikes. The S&P rose above its 200-day moving average for the first time since April while the DJIA exited bear market territory. This led to strength for some rate-sensitive growth names, including gains of more than 12.2 percent by Netflix and more than 10.8 percent by Meta. Friday’s strong jobs report did complicate the picture, with wage growth coming in much higher than expected and reversing some gains from Powell’s comments as inflation concerns creeped back in. The top-performing sectors were communication services, consumer discretionary, and health care. Under-performing sectors included energy, financials, and utilities. 

 Federal Reserve (Fed) Chair Jerome Powell gave a speech last Wednesday in which he stated, “Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases.” While much of his speech explained that restrictive policy may be required for some time in order to get inflation down—specifically noting high wage growth—the market latched on to his moderation comments. Yields fell across the U.S. Treasury curve as a result, with the 2-year, 5-year, 10-year, and 30-year dropping 15 basis points (bps) (to 4.31 percent), 12 bps (to 3.74 percent), 18 bps (to 3.52 percent), and 10 bps (to 3.63 percent), respectively. Expectations for the terminal rate still hovered near 5 percent by the Fed’s March meeting, but with a slower pace of rate hikes, there is still plenty of data that could change between now and then. 

Last week’s data was lighter than usual due to the holiday, but the release of durable goods orders and the November FOMC minutes helped provide insight into economic conditions and policy. Equities moved higher as earnings and Fed speak about potentially slower rate increases moving forward helped lift markets. Dell (DELL), HP (HPQ), Analog Devices (ADI), and Deere & Company (DE) all posted modest earnings. While the semiconductor space will take any positive news it can get due to recent headwinds, HP announced it will lay off 6,000 employees through the end of 2025 amid cost cuts. The potential for slower rate increases, however, did not immediately lift growth stocks. The top-performing sectors last week were utilities, materials, financials, and consumer staples. Sectors that underperformed included energy, technology, and consumer discretionary.

 After the Federal Reserve (Fed)’s fourth consecutive rate increase of 75 basis points (bps), the recently released minutes from the early-November meeting indicate that most Federal Open Market Committee (FOMC) members could support dropping to a smaller rate hike when they reconvene in December. “A substantial majority of participants judged that a slowing in the pace of increase would soon be appropriate,” the minutes read. This comes as inflation remains at a stubbornly high level but is showing signs of potential moderation moving forward. While the pace of ongoing rate hikes is certainly an important piece of the puzzle, market participants are also looking for more clues as to what a likely terminal value may be at the end of the cycle.

Despite seeing some recent data that potentially points to a slowing pace of inflation, there is still tightening to be done. Core Consumer Price Index (CPI) data for October increased 0.3 percent month-over-month, but Federal Reserve (Fed) officials have indicated that this better-than-expected result should not be seen as a sign that the inflation fight is over. St. Louis Fed President James Bullard noted, “Thus far, the change in monetary policy stance appears to have had only limited effects on observed inflation . . .” He went on to say, “ To attain a sufficiently restrictive level, the policy rate will need to be increased further.” The U.S. Treasury curve twisted slightly last week. The 2-year and 5-year gained 17 basis points (bps) (to 4.5 percent) and 4 bps (to 3.98 percent), respectively. The 10-year and 30-year fell 2 bps (to 3.79 percent) and 13 bps (to 3.89 percent), respectively. 

The week wrapped with the release of existing home sales for October. Existing home sales fell less than expected. This does mark 10 consecutive months with declining home sales, however, as rising prices and mortgage rates continue to cool the housing sector.