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.
Primary Economic Drivers
The four primary economic factors that can explain roughly 86% of all market deviation continue to fight their trends. This counter-trend movement in the factors is pushing equity markets higher. There are better situations for macro traders in the short run. However, taking a step back, we can see that despite the market direction, the business cycle is still the main economic driver and is still approaching a recession.
Risk On Risk Off of Major Asset Classes
Unchanged
The Current economic environment defined by the economic driver does not support equity markets or corporate debt but supports treasuries, specifically long-duration treasuries. Another case for supporting long-duration treasuries is the market when the two-year treasuries yield drops below the Federal Funds Rate. This is likely to occur shortly after the Federal Reserve raises rates today. The only signal we would be looking for would be a confirmation in our trend model, which has been trending down all of 2022.
| Domestic Equities | Small Value | High Yield | Investment Grade | Treasuries | Commodities | |
| Risk-Off | Risk-Off | Risk-Off | Risk-Off | Risk-On | Risk-Off |
Equity markets continue to fight the macro environment, moving up while the climate suggests that it should be falling. This is because we are in the very late stages of an imminent recession where lower inflation (typically a bad sign) is giving hope that the Federal Reserve will pull off a miracle with a soft landing. A soft landing is highly unlikely to do the long and variable lags in monetary policy and the fact that rates of 4.25% are still not yet at a neutral rate estimated to be higher than 5%.
In the short run, markets trades from emotion, but in the 6-to-12-month range, they trade off fundamentals. Our overall outlook remains on the downside until the macro environment changes.
Economic Growth
Unchanged
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
Updated
The 3Q22 earnings season showed a mixed picture of corporate resilience, with pricing power differentiating winners from losers in the face of rising costs. Our current estimate for 3Q22 S&P 500 operating earnings per share (EPS) is $50.28, representing a year-over-year (y/y) decline of 3.4%. 58% of companies beat earnings expectations, and 54% surpassed revenue expectations. Management commentary constantly referenced the impact of higher interest rates, shipping costs, and a stronger US dollar on earnings. Earnings expectations for 2023 likely have to come down to reflect the slowing growth backdrop, which could lead to further equity market volatility.
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
Updated
The November Jobs report was strong at the surface, with an above-consensus gain for payroll jobs and a rise in average hourly earnings. However, both the details of the payroll report and a broader view of the labor market suggest moderation is continuing after strong gains earlier in 2022. In particular, this morning’s report showed a second consecutive monthly decline in employment as measured by the household survey and a fall in temporary workers, which often serves as a warning sign of weakness. Unemployment remained constant at 3.7%
However, the ADP private payrolls report came in today and showed that employers added 235,000 jobs in December, well above economist estimates. Wages also increased more than anticipated, another sign that the labor market remains hot. Later in the morning, weekly jobless claims came in below expectations and showed a drop in continuing claims.
While we will get a better overall picture of the jobs market tomorrow, private payrolls beating expectations and jobless claims below indicate that the labor market remains resilient. But do not be fooled by these numbers; a strong labor market is typically right before a recession, as higher interest rates and slowing growth tends to impact the labor market last when it is too late.
Inflation
Unchanged
Inflation came in below expectations for the second consecutive month and reinforced the turning tide on inflation as nearly every major category showed easing price pressures. Headline inflation rose by 0.1% m/m, and core inflation rose by 0.2% m/m, bringing the year-over-year rates down to 7.1% and 6.0%, respectively. Prices for energy and core goods contracted, while services ex-shelter inflation decelerated. We expect inflation will continue to trend downwards in the months ahead, given easing supply constraints, cooler demand, and lower commodity prices.
Rates
Unchanged
Despite a recent inflation moderation, the Fed has maintained its hawkish messaging on monetary policy. At its December meeting, the FOMC hiked rates at a reduced pace of 0.50% to a range of 4.25%-4.50%. Markets were most surprised by the Fed’s updated Summary of Economic Projections, which showed a picture of higher unemployment, higher inflation, and slower growth in 2023 and 2024. The median FOMC member expects a terminal rate at or above 5% next year. Further cooling in inflation data may allow the Fed to pivot before hiking rates above 5%, but the risk of the Fed overtightening and inducing a recession remains elevated.
Risks
Updated
Fed is likely to 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
Unchanged
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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