January 2023 Market Update

The Federal Reserve is going to keep financial conditions tight until they are confident inflation is back to their 2% target. The terminal rate for the Fed to stop raising rates is now 5%. The Fed has implied they could move to 5.5% if market conditions suggest it to be necessary to bring down inflation. The fed fund futures curve is now pricing in rate cuts for 2023 which is indicative of the bond market pricing in recession and the national unemployment rate moving greater than the Federal Reserve’s 2023 forecast target of 4.5%.

Market participants continue to suggest that the labor market shows signs of strength, but we believe this is overshadowed by average hours worked declining which has pushed average hourly earnings up. This represents a deteriorating employment situation. Meanwhile the twelve-month rolling average jobless claims data shows a new uptick trend beginning to appear.

The 10-year minus 2-year yield spread continues to forecast recession and we think the yield curve is right. Leading Economic Indicators, published by both the Conference Board and Economic Cycle Research Institute, also suggest an incoming recession. Data from leading economic indicators such as NAHB, ISM manufacturing new orders, NFIB small business outlook and consumer sentiment continue to deteriorate and suggest further economic weakness in the months ahead.

This all suggests a deterioration in the S&P500 earnings forecast for 2023. The S&P500 is currently valued at 16.8x next year’s earnings. We believe earnings estimates are vastly overstated based on economic weakness from the business cycle. Indications from a lead earnings indicator, Chicago PMI data, is at the lowest level since the 2008 financial crisis. For those reasons we believe the $225 earnings forecast for 2023 will be cut by 20% or more. This implies a much lower valuation than 3,780 or (16.8 x $225). Using the same multiple of 16.8x and reducing the earnings estimate by 20% down to $180 we could see a more reasonable valuation being near 3,050. However, if we take the historical average recessionary price to earnings ratio of 13.5 (13.5 x $180) then 2,430 is the output.

So how do we know when the worst of the earnings cuts will be over? Even though we will watch S&P500 companies respond to a lower growth environment through cuts in operating expenses and capital expenditures, determining the correct multiple and earnings amount will depend on when the earnings recession has bottomed. We believe the earnings recession for the S&P500 will bottom with earnings estimate revisions moving from decreasing at an increasing rate to decreasing at a decreasing rate. Which means the rate of change has formed a new trend in the earnings data. We currently believe that will occur near the S&P500 3,050 level. Ultimately, a recession cannot peak until credit spreads have peaked, unemployment has peaked, and earnings estimate revision data has bottomed.

This combination of Federal Reserve policy to combat inflation within a deteriorating economic cycle will continue to weigh on risk asset valuations until the Federal Reserve has achieved their inflation target of 2% and the economic cycle has bottomed. The economic/business cycle begins with housing and ends with employment. Which is why we believe investors will continue being rewarded with risk free interest and cash until the unemployment rate rises north of 4.5%.

We expect during recession for the yield curve to re steepen. We expect a bull steepening. Bull steepening occurs when the 2- year yield falls at a faster rate than the 10-year yield as the yield curve moves to normalize whereas the 10-year yield is once again greater than the 2-year yield and no longer inverted. We expect bull steepening because we feel that like the Federal Reserve’s forecast target of 2% inflation, the conclusion of the 2023 forecast target of 4.5% unemployment rate will result in a similar outcome and therefore another policy shift.