Summary
- January was an anomaly in terms of economic strength, but it served a three-course meal for the bearish narrative.
- To adjust for a recession that has not yet occurred, a "no landing" scenario has been introduced.
- Yet the outlook for growth increased last week, while the outlook for inflation decreased, which looks more like a soft landing.
- We may see a further pullback in the S&P 500 to consolidate year-to-date gains, but that should lead to more gains ahead.
One week ago, I surmised that a hotter-than-expected CPI number could be the catalyst to fuel further downside in a much-needed correction for the major market averages. It would serve as red meat to temporarily feed a starving bearish narrative, clear out the weak shareholders, and find a higher bottom in the S&P 500 (SP500) that refreshes the new uptrend. I didn’t expect a three-course meal, as the Consumer Price Index, retail sales, and the Producer Price Index were all stronger than expected for January. That not only brought the bears out of hibernation, but Fed officials who were quick to warn that economic resilience could result in short-term interest rates that are higher for longer. Common sense dictates we would have seen a sharp decline in stocks and rise in interest rates, but neither happened. In fact, the major market averages were relatively flat, while rates saw only a modest increase. The market continues to price in a soft landing.
To help explain what seems to be inexplicable for those who don’t believe in soft landings is a new term called the “ no landing .” The consensus view on Wall Street has been that the economy would succumb to the pressure of monetary policy tightening, as the Fed attempts to slow growth and bring the rate of inflation down to 2%, resulting in a hard landing or recession. I have been in the camp that inflation can return to pre-pandemic levels, as the rate of economic growth slows, without causing a recession, which would be a soft landing. Confounded by the strength of the economy to date, some are now forecasting a “no landing” scenario in which we avert a recession on the strength of the consumer, but it comes with sticky inflation that results in higher interest rates for longer, which will deal a crushing blow to the stock market.
That looks more like a much-needed pivot in the bearish narrative, due to the fact that the recession forecast isn’t working out, but the call for sticky inflation should turn out to be just as poor. As for economic growth, the Atlanta Fed’s GDPNow model increased its forecast for growth in the first quarter after last week’s data from 2.2% to 2.5%. I will be the first to admit that we will likely see some moderation in that estimate after February’s numbers, because January was an anomaly in terms of its strength, but there are still no signs of recession in the real economy.
Stronger growth comes with another decline in inflation, according to the Cleveland Fed’s Inflation Nowcasting model , which lowered its estimate for the Consumer Price Index and Producer Price Index in February on a year-over-year basis over the past week. The CPI estimate on February 10 was 6.35%, and now it has fallen to 6.24%, while the PPI was at 4.85%, and it now sits at 4.74%. This is more progress.
What is even more encouraging is the progress we are making in the first quarter on an annualized basis. The Cleveland Fed’s model projected a CPI of 5.38% on February 10, but that has fallen to 4.68%.
The core CPI rate has fallen from 5.28% to 5.04%, while the PCE has fallen from 3.86% to 3.46%. We saw no progress in the core PCE, but I expect we will in coming weeks. The rates of change are all moving in the right direction.
The best part of last week’s inflation report was that housing accounted for half of the annualized increase. We know that the rate of increase in home prices and rents has fallen sharply. In fact, nationwide home prices have declined over the past six months. Still, it takes several months for these new monthly prices to bring down the annualized rate. Simple math shows this should happen this summer. Regardless, the futures market is pricing in a possible third 25-basis-point rate increase in June of this year, which would take short-term rates to 5.25%. I’ll believe it when I see it.
Edward Jones
If the no-landing scenario is relying on higher interest rates to keep the bear market rolling, that picture doesn’t look good, either, if we use commodity price movements as a precedent. Long-term bond yields and commodity prices have consistently trended in the same direction over the past ten years with commodity prices leading. The two have diverged for the better part of a year since the Fed started raising interest rates. The decline in commodity prices continues in aggregate, which suggests long-term rates peaked last October.
The bears need a new narrative, and I don’t think the pivot to a “no landing” scenario is it. The rate of economic growth looks slower but stable, as consumers continue to spend at a modestly higher rate than inflation. A record low unemployment rate combined with a healthy but moderating rate of wage growth is helping to offset slowly receding excess savings. We should return to real wage growth by this summer, as disinflation continues. I see the Fed’s preferred measure of inflation in the personal consumption expenditures price index ("PCE") falling within a range 2-3% this fall, which is the goldilocks scenario few are willing to accept.
I am not forecasting that the S&P 500 rockets to new all-time highs in 2023, but it does tell me that the bear market is over. It also suggests that money can be made as flows continue rotating from speculative growth to quality and value.
Economic Data
Tomorrow’s mid-month survey of purchasing managers in February from S&P Global will be our first pulse check on the U.S. economy, and I am hoping to see a modest uptick from January. Wednesday’s release of the Fed meeting minutes could be market moving, but its yesterday’s news. The most important number comes Friday with the Fed’s preferred measure of inflation in the PCE index for January.
Technical Picture
I still see potential for a pullback to as low as 3,900 for the S&P 500 over coming weeks, but I think that would consolidate year-to-date gains and set the stage for higher index levels.
For further details see:
The Bears Need A New Narrative