December 16, 2022
A dovish CPI print on Tuesday and more hawkish Fed Wednesday drive recession risk dynamics over the last two days and likely into year-end. The Fed’s policy path in 2023 will depend on incoming data with expectations for another 50bp or 75bp hike before a pause. The OIS market is currently priced for the Fed to hike by 25bp in February and 25bp in March before pausing at the May meeting. The difference between 50bp and 75bp is more meaningful than it sounds when manufacturing and services PMI is in contraction. The October and November CPI prints signaled disinflation, but labor markets remain tight and the Fed will likely stay the course until they loosen. Labor market conditions that mostly line up with ~2% core inflation include an Unemployment Rate in the 4.5%-5% range, non-farm payrolls under +100,000 and YoY wage growth under 3.5%. We expect a ‘bad news is good’ phase during most of Q1 as long as growth data doesn’t deteriorate too fast or too far. Historically, multiple ISM manufacturing prints below 50 have triggered Fed policy accommodation. ISM manufacturing for November came in at 49 and was the first sub-50 print of this cycle. Bad news would likely be bad for equities at levels below ~46. The optimistic scenario would like to see Q1 end with YoY headline CPI below 5%, 10-year nominal yields below 3.7%, the 2/10 yield spread below -10bp and the US dollar index below 95.
Over the last 40 years, all but two Fed tightening cycles have produced a ‘hard landing.’ The Fed’s current tightening campaign will most likely result in softer-than-desired economic conditions and produce a recession of some magnitude. The good news is we’re approaching the most widely predicted recession in our lifetimes that will soon be fully reflected in valuations, behavior and estimates. The optimistic conditions mentioned in the paragraph above will be hard to meet, but extremely light equity positioning will likely buffer the downside. The S&P 500 (SPX)
broke technical support at 3900 yesterday, setting the stage for a retest of the ~3550 low from mid-October. The trend now is lower and the macro catalyst vacuum that exists into year-end should keep the index on this path. While we expect a successful retest at ~3550, a sustained recovery in asset prices now requires a monetary pivot that should be reflected in bond yields ~1-3 months ahead of time. Ten year yields below ~3.10% should be the first indication with a break below ~2.90% making it apparent to everyone.