It would appear Christmas has come early for U.S. markets! The holidays are a great time for self-reflection, and when I think about this moment last year, it was quite a gloomy outlook with recession on the horizon, inflation out of control and CEO’s guiding down earnings and capital expenditures. It would appear the exact opposite came true, despite some very large challenges along the way, including both geopolitical and banking crises. Momentum, over-crowded positioning, and some U.S. Federal Reserve (Fed) “over-communication” has led to whipsawing throughout 2023, but directionally, outlooks have steadily improved all year. Amidst the “everything rally” and Fed pivot party, should we be worried about a hangover early next year?
While the data has continued to surprise, here’s what I continue to Focus on
Labor looked wobbly with November’s Non-Farm Payroll Report. The Unemployment Rate rose to 3.9%, there was broader participation and payrolls for both Non-Farm and Private sector(s) were lower. However, the resilience in December’s report continued to surprise, with 199k adds and the Unemployment Rate moving back to 3.7% (under the Fed’s Summary of Economic Predictions (SEP) of 3.8% for 2023). Certainly, United Auto Workers (UAW) members returning to work helped, but keep in mind the continuing trend in areas we’ve previously highlighted: Healthcare, Leisure & Hospitality and Government, which accounted for 94% of this month’s gains. Average Hourly Earnings also moved higher than expectations on a month over month basis. Overall, Labor remains the lynchpin to a potential soft landing, while also continuing to feed Services' inflation & Growth.
Headline month over month Consumer Price Index (CPI) advanced 0.1% in November, up from flat October, while month over month Core also moved up to 0.3% rounded. Year over year numbers were also mixed as Core stayed flat at 4% and headline moved down 1% to 3.1%. Large declines in goods prices, including holiday deals in apparel, kept the overall Core reading from being higher. The Core services segment was a bit more concerning, increasing 0.47%. Shelter and rent reversed the prior month trend and remained sticky at 0.5%. Powell’s favorite Supercore reading jumped 0.44% month over month, up from 0.22% in October. Everyone should continue to pay close attention to Shelter given it’s a large portion of the CPI calculation and Owner’s Equivalent Rent (OER) has been increasingly stubborn. I do think there is some disinflation in the pipeline, especially in Auto’s as the UAW strikes are behind us, but I continue to be wary of a potential goods reacceleration given how much of the heavy lifting it’s done over the past year. The bottom line: is that the helpful year over year comparables are behind us and much of the “low hanging fruit” of the pandemic’s inflation readings have already come out, and I would expect a continued fight to get to the Fed’s 2% target throughout next year.
Speaking of the Fed, they gave the market the biggest gift of all in ’23, inextricably (despite all the data mentioned above) forecasting three cuts in their Dot Plot for ’24, while still keeping a soft-landing Summary of Economic Projections: Gross Domestic Product (GDP) 1.4%, Personal consumption expenditure (PCE) 2.4% and OER 4.1%. As I’ve chronicled all year, Powell has had some strange press conferences and traders were already certain the Fed wouldn’t raise rates any further, but those Dots are the only thing standing between the market and easing financial conditions. I would remind my readers that despite the Dots and recent Fed messaging, Core CPI (4%) is firmly above the Unemployment Rate (3.7%) and historically speaking, unless there was a war or recession, the Fed has never actually cut rates while inflation was higher than unemployment. Despite this trend, the market is still forecasting 65% chance of cuts starting in March, which ironically is less than 65 trading days away. That feels too much too soon, while keeping a soft landing in-tact.
Reflections on rates
10-Year yields have roundtripped a 4 ½ month 100 basis points (bps) move from 4% to 5% and back down to 4% again. These types of moves are generally atypical, and U.S. Government Treasuries have become more volatile than gold this year. Auctions have been mixed, and while I’m heartened the most recent 30-year auction by the Treasury didn’t have a tail (compared with 5.1bps in November), other auctions during December have been sloppy and this will be a continuing theme throughout 2024 given the market will have to digest at least as much net new supply next year. I have previously advocated extending out duration, especially as the entirety of the curve was above 5%, but we have come very far, very fast, as the 10-year is below 4%. I would expect the bull steeping trend to continue on a longer-term basis and still favor the 2-5 year bucket, but investors should expect a “gut check” in the first half of the next year to the immaculate disinflation narrative and may find more attractive entry points should a flattener briefly take shape. I would also keep a close eye on Credit, which has seen continued tightening of spreads in both Investment Grade and High Yield sectors, while Bank Loan debt has experienced an uptick in defaults. As existing debt comes due and companies have to come back to the market at higher all-in rates, defaults could continue to push higher.
Not discussed enough
Supply chains and especially Oil prices coming down have really helped the inflation story, potentially more so than Fed Rate Hikes. But is it telling us something about demand, China, the Electric Vehicle (EV) transition/U.S. Supply, or recession?
Geopolitical tail risks are present and accumulating, and while the Fed would like to be less of a story in 2024, we will still have to deal with Israel and Hamas conflict widening, a Taiwanese election and China’s shadow looming large, Russia/Ukraine war, and U.S. election season.
Final Thoughts
We’re still in a data dependent market, and there will be a lot of data to consider over the coming months before anyone, including the Fed, can be confident we’re on the path towards 2% without tripping before the goal line. Likewise, the 140bps worth of cuts the market expects by the time we get to December 2024, seems excessive with growth and employment still intact. Don’t get me wrong, there is a ton to be thankful for this year and it is impossible to perfectly time a market peak or trough. Opportunities have presented themselves, especially in Short Duration, Agency Mortgages, Municipals and other parts of the market and U.S. economic resilience is something everyone should be thankful for – given the velocity of rate hikes and potential pitfalls that were miraculously avoided. The long-term trajectory of a bull market appears to be taking shape, but while futures markets may not always exhibit patience, I’d suggest investors find some under the tree this year.
I want to thank each of you for reading and following along throughout the year with me. I appreciate all your feedback and look forward to continuing the conversation next year. I also want to thank the amazing team of portfolio managers, analysts, traders I get to work with every day, in addition to our client coverage and marketing teams. I hope all of you have a happy, healthy, restful and safe Holiday Season and a great start to the New Year.
Until then, Stay Focused!
– George