Market Update

Summary

Economy continues to slow, but the U.S. Economy is not yet in a recession.
Labor market is still tight.
Inflation is still high, but shows signs of cooling.

Equity market

Three major indices, the Dow Jones Industrial Average, the S&P 500 index, and the NASDAQ, all show technical tops in this recent rally. Combine the technical setup with a weak forward outlook on the economy, and the market is setting itself up for another pullback. However, to have that, there needs to be some catalyst in place. This catalyst might come from more hawkish rhetoric from the Federal Reserve Chairman Jerome Powell, who will speak at the end of the month on the 30th. Or possibly more negative news from China regarding their protest and lockdown policy. Either way, we are waiting with bated breath on what will cause this market to turn to the downside.

Economic Growth

Following two consecutive quarters of negative GDP growth, 3Q22 real GDP showed the economy grew by a 2.6% annualized rate, slightly more substantial than the 2.4% consensus expectation. Much of the gains came from an upswing in trade, while beneath the surface, the economy is still losing momentum in growth and inflation. Real consumer spending continued to soften, and construction spending was very weak with the climb in interest rates. However, investment spending is still holding up, and the GDP price deflator declined markedly to 4.1% from 9% last quarter. Moreover, with pent-up demand for autos and a still very tight labor market, it’s clear the economy is not yet in recession.

Profits

The 3Q22 earnings season is ending with 90.9% of a market cap having been reported. Our current 3Q22 S&P 500 operating earnings per share (EPS) estimate is $51.17, representing a year-over-year (y/y) decline of 1.6%. So far, 57% of companies have beaten earnings expectations, and 55% have exceeded revenue expectations. Pricing power has differentiated winners and losers, as rising costs rather than deteriorating sales have accounted for weakness in earnings. Management commentary has constantly referenced the impact of higher interest rates, shipping costs, and a stronger U.S. dollar on earnings.

Omega Squared also publishes our S&P 500 EPS values, calculated differently from the Standard and Poor’s version. Our version sums all the companies’ earnings in the S&P 500 and divides that amount by all the outstanding shares. Our model confirms the popular S&P 500 version with a y/y growth of negative 2.03%; the difference is that we calculate our model daily as companies report.

Jobs

The October Jobs Report showed diminishing job momentum as the economy reached its limits on the supply of workers. Nonfarm payrolls rose by a solid 261K, above expectations. However, combined with a weaker household survey that showed a loss of 328K, this report still shows a labor market that is cooling down. While supply-demand dynamics remain tight, annual wage inflation has now fallen to 4.7% after peaking at 5.6% in March. Moderating wage growth provides an essential signal for the Fed that tightness is not contributing to accelerating wage inflation.

The labor gap is my preferred method for linking the business cycle and labor market from a monetary policy perspective. The labor gap is the difference between the unemployment rate (U-3) and the natural unemployment rate. The natural unemployment rate is the rate consistent with full employment, the rate at which the economy can tread on a balanced growth path. Monetary authorities tend to look at this gap when assessing the need for further monetary policy action to bridge the hole, making the labor gap a monetary policy tool for gauging employment slack. There is little slack in employment when the labor gap is below 0, and wage inflation should rise. The labor gap helps us understand why the Fed raises rates when they do. They believe that inflation pressures become an issue when the gap is below zero.

The Labor Gap is still well below the natural rate of unemployment, still suggesting that unemployment is inflationary. The Federal Reserve will likely continue to be restrictive if this spread remains below zero.

Inflation

After many months of upside surprises, hot inflation is finally beginning to cool down. The October CPI report showed a picture of receding inflation pressures across various sectors of the economy. Headline CPI rose 0.4% m/m, and core CPI rose 0.3% m/m, translating to annual rates of 7.8% y/y and 6.3% y/y, respectively. While energy prices bounced, it was offseted by lower utility prices. Food inflation improved, with strength primarily coming from “food away from home.” Notably, prices for core goods and services ex-shelter are showing promising deceleration. As wages continue to cool and pent-up demand for services softens, we expect services inflation will continue to moderate but at a slower rate than expected because of the excess demand in job openings.

Stick CPI, excluding food and energy, shows a slight change in the trend to the upside. But with year-over-year growth at 6.35%, the Federal Reserve has some work to do.

Rates

Persistent inflationary pressures have pushed the Fed to accelerate its rate-hiking trajectory. At its November meeting, the FOMC announced another 0.75% increase in the federal funds rate to a range of 3.75%-4.00%. The committee’s tone remained hawkish and inflation vigilant. Still, investors took initial relief at the new statement language acknowledging the significant tightening the Fed has already delivered and the lags with which it will affect the economy and inflation. However, Chairman Jerome Powell’s rhetoric in the subsequent press conference was increasingly hawkish, suggesting that the risk of Fed overtightening remains.

Risks

Fed could push the economy into recession if it overtightens policy in response to supply-driven inflation.
Heightened geopolitical tensions with Russia could result in continued energy shortages, low consumer confidence, and dampened growth.
Markets may remain depressed and volatile until investors receive clarity on inflation and the Fed.

Investment Themes

As the rate hiking cycle is slowly ending, with the monetary policy cycle close to its max restrictive zone, fixed income is starting to show signs of life. The yield curve inversion of 10-year treasuries, less 2-year treasuries, suggests that rates should soon fall on the long end of the yield curve. Thus, high-quality fixed income with longer duration is starting to look attractive. Fixed income with low exposure to credit risk offers more protection against market correction or economic downturn.
U.S. Equities are now under pressure as forward earning expectations are likely to lower for the 2023 earnings season as we approach the upcoming recession. The bear market that started in early 2022 will continue through 2023 until the economic and profit cycles reverse.

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