QVMS - U.S. Inflation Cools But Data Provides Mixed Bag For Markets

Summary

• Why the second half of 2023 may be good for markets.
• Inflation may be cooling, but the labour market isn't.
• Why investors are having a mixed reaction to encouraging CPI numbers.

U.S. consumer inflation data showed prices softening in December. Greg Bonnell speaks with David Sekera, Chief U.S. Market Strategist at Morningstar Research, about what the latest CPI numbers could mean for markets in 2023.

Transcript

Inflation has been front and center for investors for some time. This latest read on US consumer costs showing those price pressures are gradually easing. So what does it mean for the markets this year? Joining us now with more, David Sekera, Chief US Market Strategist at Morningstar Research.

David, great to have you on the program, particularly on a day like this. We are getting further indications that inflation continues to ease, though still uncomfortably high. What do we make of it as investors?

Well, I think today is actually a great indication of what we expect the market to look like, certainly over the next couple of months. Our 2023 outlook, we titled that near-term turbulence but clearer skies ahead, and what I'm thinking is that this year is going to be a tale of halves. I think we're going to see a lot of volatility in the first half of this year, but then by the second half of the year, a lot of the headwinds that we had noted in 2022 really should not only abate, but probably start turning into a couple of tailwinds. And I think that will help the markets start to recover towards what we think long-term intrinsic valuation for the markets are today.

So with inflation the key, obviously, and we did see that read where we're starting to see-- you're seeing the gradual pullback off of the high levels. It does sound, as you're laying out your case for this year, of a longer-term play. We're not going to get a dramatic shift overnight. We're sort of just going to whittle away at it.

Yeah, so in 2022, we noted that coming into the year last year, we thought the markets were overvalued. We think that things have just swung too far to the downside, and the market's actually now pretty significantly undervalued. Now, there were four headwinds that the market had to contend with last year. We think two of them are starting to abate. So we do think that the preponderance of the increase in long-term interest rates that we expected is behind us at this point.

We also noted that we thought that inflation had peaked a number of months ago, and it is still continuing to come down. We're looking at 2.9% average inflation for this year, and, in fact, even getting down below 2% next year. So really the two things that I'm watching for the first half of this year are the US economy and the Federal Reserve.

Now, as far as the US economy goes, while things in the fourth quarter for 2022 shaped up to be kind of OK, we do think the economy is going to be soft here for the next two quarters, pretty stagnant, even potentially recessionary before it can start to reaccelerate in the second half of the year. And then, as far as the Federal Reserve goes, it does look like we have at least one more, if not two more, rate hikes before they pause.

Now, part of the reason that we think things will start to look better in the second half of the year is that we do think that with the Reserve really starting to pause on their hiking, they can actually start shifting their focus back towards their dual mandate-- so not just inflation, but also maximizing the economy to be able to get to full employment. And so in the second half of the year with inflation continuing to decline, with the economy being stagnant in the first half, that actually would give them the reason to actually pivot and, in the second half of the year, turn to an easing policy.

That's the great debate, it seems, at the start of this year between what the Fed and other central banks have been telling us, saying, listen, we got maybe a bit more ahead of us, and then we're going to stay at that level for a while. But the bond market is saying, no, we don't think so. We're going to think you're going to be cutting by the second half of the year. Is the bond market going to prevail in this sort of divergence of views?

Well, the bond market is always called the 800-pound gorilla in the room, so you certainly have to pay attention with the bond market, its pricing in. As far as long-term interest rates, we think that we're pretty much at the average of what we're expecting for this year at 3 and 1/2%. Now, having said that, with inflation coming down, especially in the second half of this year and into next year, we do think that there's actually room for long-term interest rates to rally. We are looking at a 2 and 1/2% rate for 2024. So I think the bond market, while last year was essentially the worst year ever that I think we saw on fixed income, things are certainly looking much better, and especially in the second half of this year for fixed-income investors.

So if we can get to that second half of the year, where hopefully things will pan out, as you're saying, and as things start to look better, how bumpy could the ride between now and then be, thinking about the volatility?

Yeah, and that's always hard to know. It does look like the market's probably put in a bottom here in the US in October of last year. So I would assume that probably should hold. Now, having said that, like you said, I think we could easily see a couple percent swings in day-to-day prices, up 5%, down 5%, on probably a trading range for the next couple of months.

And I think the market's really going to be very, very focused on the economic indicators as they're coming out. And then, over the next couple of weeks we do have earnings season here starting, and I think people are going to be focused on what 2023 guidance from a lot of companies are, especially with the banks coming out tomorrow. So depending on how that guidance shapes up, again, we could see people reevaluate what their valuations are based on those EPS numbers.

Let's talk a bit about that, because obviously, people have been warning. And I guess perhaps the more bullish argument -- sorry, the more bearish argument-- for this market has been the fact that we haven't seen the companies fully coming out and saying, OK, here's the state of the economy. Here's the change that we've seen in consumer activity because of rising rates. And here's what it's going to mean for the bottom line. We haven't fully priced that in yet. Is there any merit in that argument?

Well, there's certainly merit in that argument, but I also have to think, too, that you need to think about whether you're a trader or you're an investor. So again, looking at the market technicals, we can see a lot of volatility. People will be trying to game the markets intraday and day to day based on those economic numbers.

But I think when you take a step back and as a longer-term investor and really think about what companies can generate over the long-term and really think about-- and again, we use a discounted cash flow model here. So we're really trying to figure out, what's the intrinsic value of a company worth based on the long-term cash flow stream that company can generate? So even when you do have some short-term volatility in earnings, when you think about how much that should change the intrinsic value of a company, usually an earning beat or an earning miss, you might see a 3% to 5% move in our intrinsic value if it's different than what we expected. But really, we're looking for those changes in the underlying business over the long term and whether or not that changes our projections and our forecasts.

So again, we'll be watching and listening for that in the first half of this year with the guidance numbers, but based on what we're expecting for right now, we do think the markets are pretty significantly undervalued. And in fact, when you look at our valuations going back to 2010, we're in pretty rare territory just as far as how much the US market is trading at a discount compared to where it's been in the past. So again, a lot of volatility here in the short term, but for those investors with a longer-term focus that can weather this period of volatility, I do think that things will look much brighter in the second half of this year and going into 2024.

So longer-term horizon, things looking fairly bullish. I'm going to ask you, what could trip up that thesis? What would stop it from transpiring in the second half of this year?

Well, our base case for the US economy is, again, that it's going to be stagnant to potentially recessionary. And at this point, our US economics team is saying, hey, the potential for a recession is 30% to 50%. And if that recession does come about, I know that their base case is that it's going to be short and shallow. So if we were to have a much deeper recession and/or a recession that lasts more than just the next couple of quarters, that certainly would put a lot of downward pressure on earnings and certainly downward pressure on our valuations as well.

The other part, too, that could be a wild card is that we do think that the preponderance of long-term interest rate increases is behind us. If we were to see the 10 year really start making a move back up again in yields, that certainly could play havoc in the growth stocks. You'll see a lot of downward pressure in some of those growth mega-cap stocks that had been under pressure last year. And again, because there's such a large market cap percentage of the overall market, that could bring market valuations down as well.

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