Waiting for US CPI clarity as markets start the year with a bang

Risk is back on as we move towards the middle of January, somewhat at odds with the gloomy predictions for 2023. However, has the dial really shifted for financial markets? Is a market rally sustainable on the back of “bad” economic news, especially when the Fed shows no sign of pivoting yet? These are the questions that we are trying to answer as we move through January.  The interesting fact about the rally in stocks is that it is broad-based. It has been led by both value and growth stocks, for example, consumer discretionary is up 2.08% on Monday, and Tech is also higher by 2.56%. The sector that has been struggling so far in January is healthcare, the ultimate defensive sector, which is another sign that risk sentiment has gathered pace.

Next steps for the Fed

Rates and bonds will be crucial in 2023. While most of the market expect an earnings recession for equities in 2023, bonds are stealing the limelight, with plenty of investment bank analysts positive on the high-quality credit market due to valuations and short-term government bonds, due to the certainty of income that they provide.  However, we have had few clues about how the Fed will decide monetary policy this year. They have been firm in their message that they will take rate decisions on a meeting-by-meeting basis, however, the messages from individual Fed members have been varied. You have some, such as Neel Kashkari, who have erred on the hawkish side, and you have others such as Raphael Bostic who have said that rates are close to their peak, but they may need to stay elevated. This disparity among Fed voices is most likely intentional, as the Fed is close to an inflection point, which is when you expect Fed members to hold different views. Some will want rates to rise sharply, while others will be more cautious on the impact of growth. On balance, we expect Fed speak to help boost risk sentiment, as it reinforces the “peak rates” narrative.  

What a collapse in the ISM means for the US economy

Last week’s historical collapse of the ISM service survey spurred Friday’s broad-based market rally.  The downshift in the ISM was truly historic. The overall index collapsed to below 50, while the new orders component dropped to 45.20. There have been only a few other times that we have seen the service sector ISM drop so sharply: April 2020, January 2008, and January 2001. Back then, large declines in the service sector ISM preceded large declines in the labour force by 2-3 months. Thus, could we be past the peak for US job growth, and thus wage growth? Based on this data yes, although one caveat of that is the Christmas holiday season and bad weather potentially disrupting this index. There is a potential that could have happened, but we doubt it would have had such a sharp impact on the index. Instead, the Fed’s rate hikes could be starting to work, when this happens it brings us closer to peak Fed rates and allows us to see a glimmer of a future where the Fed starts cutting rates, potentially later this year. Therefore, the market is not mad to be rushing to buy equities and bonds and ditch the dollar. While we don’t expect asset prices to go up in a straight line, markets are not being led by animal spirits, but rather a rational view that the economy is on the turn in the US, and this could mean that the cost of capital is on its way down in the 6-9 months ahead.

Q4 earnings season to set the tone for stocks

Two things we want to watch this week: the dollar and earnings reports, particularly US banks that will release Q4 and 2022 earnings on Friday, when JP Morgan, Bank of America, Wells Fargo, BlackRock, Citigroup, and Bank of NY Mellon all report earnings before the bell. We will also be looking out for UK supermarkets and clothing retailers to see how the UK consumer held up over the Christmas period, after a better-than-expected holiday season for Next. J Sainsbury will report on Wednesday, followed by Tesco, Marks and Spencer, Whitbread and Asos, all report trading updates on Thursday.

US CPI in focus

It will be a busy week for news, both corporate and economic. Thursday will also see the release of US CPI for December, which will be a key contributor to the February Fed decision on interest rates. Interestingly, ahead of this report, US short term inflation expectations have slipped in the New York Fed Survey. One year ahead inflation expectations declined by 0.2% to 5%, the lowest reading since July 2021. Longer term inflation expectations were unchanged at 3%. We shall have to see if expectations match reality with the release of this survey. Analysts expect the annual rate of CPI to fall to 6.5%, a drop of 0.6%. This report is crucial for the market narrative that inflation will fall, the fed will stop hiking rates soon and will cut rates in the second half of this year, and markets will continue to rally.  While the market is holding out for more disinflation in December, the Cleveland Fed is predicting that prices will be higher than expected, their model is looking for price growth to be 6.6%, although the Cleveland Fed has a habit of over-estimating price growth. So, a lot is resting on this inflation report. But it is worth noting that since 1960, a peak in inflation usually comes when there is a recession. Thus, there could be tough times ahead, even if the market is looking to greener pastures in the future.

The market reaction

From an asset price perspective, we are watching the dollar closely, after the dollar index fell to a 7-month low on Monday. We will also be watching how equities cope with US inflation and the start of Q4 earnings season. As we get closer to the end of the week and these key data releases, we would not be surprised to see equity markets cool, give back some of their gains and trade sideways, likewise for the dollar sell-off to come under some pressure.