December headline CPI is estimated to have decreased by 0.1% month-over-month, lowering the annual rate of increase to 6.5% from 7.1% previously, according to Bloomberg consensus forecasts. Core CPI is estimated to have increased by 0.3% month-over-month, up from 0.2% in November, but the annual rate is forecast to drop to 5.7% from 6.0%. Fed fund futures markets are pricing a 75% chance that the Fed will reduce the size of its rate hike for a second consecutive meeting, to 25 basis points in February from 50bps in December.


But regardless of the outcome of today’s data, we continue to believe that it’s too early for an imminent Fed pivot and the conditions are not yet in place for a sustainable equity rally.


A pause is not a pivot…The Fed is getting closer to the end of the rate hiking cycle, which we believe is likely by the end of the first quarter. But Fed officials have reiterated this week that rates are likely to remain at their peak level for some time before easing starts. Core CPI falling back below 6% would be a step in the right direction, but inflation remains far above the 2% target. The Fed has also expressed concerns that the recent loosening of financial conditions could complicate its task of reining in inflation.


…particularly given the tightness of the labor market. High-profile companies are starting to shed labor: Goldman Sachs began cutting 3,000 jobs this week and major tech firms including Amazon, Meta, and Twitter have already started to lay off employees in recent months. But, in aggregate the labor market remains tight. The December unemployment rate, which fell from 3.6% to 3.5%, now matches a 50-year low. The JOLTS survey data showed there are 1.74 vacancies for every unemployed person and the quit rate, which is correlated with wage growth, remains high. The Fed has said that wage growth is not consistent with its inflation target.


The economy and corporate earnings do not fully reflect the impact of prior tightening. The Fed has raised rates by 425bps in just a year, and the impact has not fully fed through to the real economy. While the housing and manufacturing sectors were among the first to feel the impact, the services sectors are only just starting to slow in December, based on ISM PMI data. In our view, the slowing economy will eventually take a toll on S&P 500 earnings, which we expect to contract at a mid-single-digit percentage rate in 2023, compared with consensus expectations for earnings growth of around 5%.


So, we continue to believe that we have not yet reached the inflection point in policy or economic growth. As we enter 2023, we continue to favor a defensive tilt in both our equity and fixed income exposure. For more risk-tolerant equity investors looking to identify parts of the market that could rally most strongly should the inflections arrive, we see select opportunities in early-cycle markets, like Germany, “deep value” stocks, parts of the semiconductor sector, and the likely beneficiaries of China’s reopening.


Main contributors - Mark Haefele, Patricia Lui, Vincent Heaney, Jon Gordon


Content is a product of the Chief Investment Office (CIO).


Original report - Receding inflation is necessary, but not enough for a Fed pivot, 12 January 2023.