January 2023 Market Commentary

February 14, 2023

Maybe it was simply the act of turning the calendar to 2023, or that investors were tired of markets going down, or signs that the Fed is nearing the end of its rate hikes, or that maybe, just maybe, a “soft landing” is possible. Whatever the reason, investors were in an upbeat mood in January, propelling large caps (S&P 500) to a 6.0% return. Riskier asset classes faired even better, reflecting the overall “risk on” mood of the market. Small caps gained 8.5%, while the tech-heavy NASDAQ, which lost 1/3 of its value in 2022, rebounded 11.0% in January. International markets also generated strong positive returns, with developed (MSCI EAFE) and emerging markets (MSCI EM) gaining 8.5% and 9.9%, respectively. Despite the market gains, it may be premature for investors to take a victory lap quite yet. After all, history is replete with numerous examples of victory being prematurely claimed, including the (in)famous “Dewey Defeats Truman” headline. That said, at the margin, there is a growing sense that perhaps 2023 won’t be as bleak as many were predicting just a few months ago. Of course, whether or not one agrees with that assertion is largely a function of their perspective(s). One thing for certain is that there currently exists a wide range of opinions surrounding nearly every data point and by extension what that means for the broader economy and financial markets.

Take, for example, 4Q22 GDP data released in late January. On a headline basis, the 2.9% growth was down just 0.3% from 3Q22 growth of 3.2%, and better than the consensus forecast of 2.8%. Optimists, or “bulls”, were quick to point out that consumer spending remained relatively robust at 2.1%, while the other three components of GDP- business spending, trade, and government spending- were positive as well. Pessimists, or “bears” were more skeptical, noting that consumer spending slowed over the course of the quarter and was actually negative in both November and December, suggesting that the economy entered 2023 with diminished momentum. Another item that generated interest, as well as debate, was a sharp rise in inventories, which accounted for half of the total headline GDP growth. Bulls argued the build was evidence of improving supply chains and businesses anticipating continued consumer demand. Bears, however, argued that the build was the result of slowing consumer demand leading to bloated inventory levels. In turn, businesses will be forced to discount inventories to sell them, resulting in reduced margins which could exacerbate existing concerns about 2023 corporate earnings growth.

Another example of the significant uncertainty currently facing markets was the interpretation of the January employment report. Here again bulls and bears had very different takes. After experiencing four consecutive months of slowing, nonfarm payrolls added 517K new jobs in January, the fastest pace of growth since July. At the same time average annual wage growth slowed from 4.8% to 4.4%. Bulls viewed the combination of strong job growth and slowing wages as a “goldilocks” situation. One that simultaneously demonstrated that the economy remains healthy while inflation is cooling, thereby not placing additional pressure on the Fed with respect to future rate hikes. Bears focused primarily on the level of job growth arguing it would put additional pressure on the Fed to maintain or increase its current inflation-fighting efforts. Since initiating rate hikes in March of last year, the Fed has indicated that its actions would result in “pain” primarily in the form of slower economic growth and higher unemployment. While the former has come to pass, that latter has not. For bears, the concern is that January’s employment report might incentivize the Fed to act even more forcefully to quell inflation and in doing so tip the economy into recession.

Inflation readings provide a final example of the wide range of opinions surrounding economic data. Consumer price (CPI) data released in January showed that headline inflation slowed to 6.5% in December, a sharp 0.6% decline from November. For bulls, the decline was further evidence that the Fed’s rate hikes are working and that it might soon be able to conclude its current rate hike cycle. Bears argued that beneath the surface, the decline in inflation has largely centered on goods but that services inflation, which is often described as being more “sticky”, i.e. slower to change, remains robust. Fed chair Jay Powell acknowledged as much in early February when he said that while the “disinflationary process” has started it has yet to show up in services prices which constitute the majority of the Fed’s primary inflation gauge. For bears, the fear is that the underlying strength in core inflation might ultimately force the Fed to raise rates beyond current market expectations in order to return inflation to the Fed’s long-term target of 2%.

In the near-term the wide range of opinions and interpretations of economic data is likely to persist. The Fed does not meet again until late March at which time it is expected to raise rates by another 0.25% as well as provide an update to its famed “dot plot” projections for future interest rates. In the interim, investors will remain focused on inflation and other measures of economic growth. Markets, for their part, will likely remain volatile, taking their lead from the prevailing interpretation of data at any given moment, be it bull or bear.

Similar to equity markets, bond markets enjoyed strong returns in January, with the Bloomberg US Aggregate bond index, the broadest measure of the US bond market, climbing 3.1%. The gains occurred primarily at the start of the month and were driven by a series of inflation and inflation-related, readings. In Germany, inflation slowed from 10.0% to 8.4% suggesting that, like in the US, European inflation is receding and thereby potentially taking pressure off the European Central Bank with respect to its own rate hike cycle. A sudden drop in the US ISM Services Index also aided bond market performance. The decline, the first since the pandemic, pointed to slower economic growth and with it the potential to slow services inflation, which has otherwise defied the general improvements in headline inflation. The previously discussed slowing in US wage growth along with a 9% decline in oil prices at the start of January also benefitted the bond market. Though Treasury markets vacillated for the remainder of the month, they ultimately ended near the levels crafted at the start of the month.

Municipal bonds, in contrast, rallied throughout the month. In addition to the Treasury rally, a supply/demand imbalance provided a further boost to the muni market. The muni market had been plagued by mutual fund outflows, posting the largest yearly decline on record in 2022. As that has reversed, selling pressure has subsided. At the same time, new issuance has slowed to a crawl as issuers wait for a sign from the Fed that they have reached a peak in rates. With new issuers on the sidelines, and mutual funds rotating from sellers to buyers, supply has been crimped while demand has surged. Demand has been driven by the likelihood that inflation has peaked, renewed mutual fund interest, and reinvestment activity that is typically very high in January for municipal investors. As a result, municipal bonds outperformed the Treasury rally.

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Information and research contained herein do not represent a recommendation of investment advice to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment, and it does not constitute an offer or solicitation to buy or sell any securities. It is not possible to invest directly in an index. There is no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. Past performance is not a guarantee of future results. These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. The views and opinions expressed in this publication are subject to change, at any time, without advance notice or warning.