The Battle for 2023 Will Come Down to a Game of Chicken
Investors are betting we will see Fed Rate CUTS at the end of 2023. The Federal Reserve is saying "Not so Fast!!". Whoever wins this game of chicken will dictate how 2023 market will perform.
Cartoons of the Week:
Oh, the Games We Play…
There is a game of chicken going on right now in the markets.
This game, and its outcome, will determine how specific investments, along with the overall market, will perform in 2023.
I have a hunch about who will win this game. If I am right, we can use this outcome to position in the markets accordingly.
Since this is my first write-up of 2023, I thought I would keep it light-hearted. I decided this week to have Peter Griffin help us with our discussion today.. We will get back to more serious commentary next week……
Meet the average investor.
Mr. investor has felt really good about his investments heading into 2022. He was on an emotional high from the previous few years of the markets moving higher.
But after 2022, something changed. A chicken named Jerome Powell, the chairman of the Federal Reserve came along and scared all of us.
Meet Jerome Powell.
Mr. Powell is here to rescue the markets from the highest inflation spike we have seen since the 1970’s.
But Mr. Powell does not have full control of the market or what caused this inflation spike. As a result, he started to use the only instrument he can control.
Interest rates.
At the beginning of 2022, he started raising rates at the fastest pace in history.
As a result of these increases, the markets had a huge adjustment lower in 2022.
First, the equity markets entered a bear market.
The bond market faced one of the worst years on record.
And investors as a whole have lost more money in a diversified portfolio than any time in the last hundred years.
By the end of 2022, every investor just felt like they have been through a 12-round fight….And lost…
So who would blame Mr. Investor for being a bit mad anytime they see Mr. Powell?
While Mr. Powell has studied history and knows how sticky and persistent inflation can be…..
Mr. Investor thinks inflation is the story of 2022 and is trying to force Mr. Powell and his friends to reverse their policies.
To do this, they have used the 10-year treasury as their crystal ball of the future.
While Mr. Powell continues to push up rates through short-term interest rates like the 2-year yield, Mr. Investors are pushing the 10-year yield lower, telling Mr. Powell they do not agree with his outlook or policies.
This battle, or a game of chicken, has done something that has predicted a recession every time since World War II. It has inverted the yield curve.
When you can earn more on a 2-year treasury than you can on a 10-year treasury, it means the policymakers and the investing public are at war.
Mr. Investor thinks inflation is over and growth will slow significantly.
Mr. Powell thinks inflation will be sticking around and only move lower gradually. As a result, he feels rates need to move up more and stay where they are once finished.
Let the 2023 game of chicken begin!!!!
Round 1 - December Employment Data
When the December jobs report came out on January 6th, it has a little bit of excitement for everyone.
Mr. Powell got in the first shot when we saw the headline of the unemployment rate falling and more jobs than forecasted being created.
If the employment market continues to stay strong, Mr. Powell has the ammo to raise rates and keep them elevated for longer.
But looking deeper into the report, Mr. Investor snuck in a few shots.
He quickly highlighted that average hourly earnings came in below estimate and have fallen over the past few months.
As hourly earnings are usually a leading indicator of how strong the employment market is, Mr. Investor highlighted this is the beginning of the weakening of the US employment data and as a result, thinks the Federal Reserve should stop raising rates and look to cut rates in the future.
The first round of the game of chicken was a draw…
Round Two - Inflation Data
As we entered the second week of the year, everyone had their eye on the CPI inflation data coming out on the 12th.
The headline came out in favor of Mr. Investor. We saw inflation moving lower to start the year.
This was a huge change in momentum and saw Mr. Investor land a number of haymakers against Mr. Powell.
If you dug deeper into the data, you clearly saw that inflation has reversed course and has started to move lower much faster than Mr. Powell has originally thought.
With shelter being the biggest lag in the data, we can clearly see using normalized data (see below) that inflation will be below the Fed’s 2% threshold very quickly.
The Next Few Rounds
So here we sit after two big data points out in the new year with both Mr. Investor and Mr. Powell feeling a bit beaten down.
Forecasted market data of inflation looking out 1, 2, and 3 years shows investors are betting inflation is over and within a year will be below the Federal Reserve’s target of 2%.
How can they be so confident?
Well, while Mr. Powell is using the 1970s as his guide to fighting inflation, investors are telling him he is looking at the wrong data points.
He should instead look at the example of the 1918 flu pandemic, which also saw a significant spike in inflation only to see that inflation disappear when the pandemic was over.
And while investors have been betting on lower inflation for a few months now, we are just starting to see them baking in Fed Rate CUTS at the end of 2023.
How will this play Out?
As we progress through 2023, I feel the data points coming out will favor Mr. Investor.
Inflation is falling. Leading indicators and leading sectors like housing have been falling.
As we get a much clearer picture of this trend out in the next few months, we should see a continuation of some positive trends we have seen to start 2023 like:
Equity market rally
Bond market rally
The weaker dollar is good for Emerging Markets, Gold, and even Bitcoin
I suspect as we approach the end of the first quarter and move into the second, the talking points on a “soft landing” and minimal to no recession will increase.
What is a soft landing? It is the idea of inflation going away without a huge hit to the labor market. If we continue to see a strong jobs market at the same time inflation declines, this is the best outcome we could have ever hoped for in 2022.
I would use any strong market action in the first and second quarters to lower risk by moving to cash or bonds.
I think investors are too focused on the past 12-18 months and not focused on the future.
As the rate hikes start to hit the market by mid-2023, consumer spending will slow, company earnings will decline, and we will face more recessionary pressures.
And just when Mr. Investor starts to put real pressure on Mr. Powell to reverse policy and cut rates, he will make the ultimate move and say NO, pinning Mr. Investors in investment vehicles that may face more pressure as we end 2023.
Ultimately, I do not think the Federal Reserve will blink. I think they will do everything in their power to keep rates at 5% or higher for the foreseeable future.
Not until Mr. Investor fully factors this in are we in the clear to go all in on the markets again.
So don’t get sucked into the optimism 2023 will provide.
Stay prudent.
We will not be seeing a “V-shaped” recovery like in 2020. This will be a prolonged malaise of growth and inflation shocks. The pain Wall Street felt in 2022 is just now starting to creep into main street. 2023 will be the story of main streets pain from the adjustment to the rate hikes that we saw in 2022.
If you are investing in a 401K for the long term, increase your investment percentages. We will get great opportunities now and throughout 2023 to buy “low”. Returns over the next few years do not matter to you. Use this volatility as an opportunity to put new dollars to work that will ultimately lead to more wealth in five to ten years.
If you already have your wealth, look to cash, bonds, high-yield bonds, gold, and potentially international equities in 2023.
US equities will again be leaders in this market. We just cannot make a full pivot to them until we finally see Mr. Investor capitulate to Mr. Powell.
Have a great weekend.