There are moments when the direction of the markets are hinged on seemingly binary situations. For example, the economy is either shut down or re-opening; there will be a war or not; inflation is rising or declining. Markets can be good at filtering out one binary event as the key determining factor for markets. Using the research and analytical tools available to them, portfolio managers are forced to pick a side. As we approach 2023, we feel investing will be confounded by two primary binary events that are interrelated with equal influence on market direction. The first is the narrative that the Fed will reduce the size of their rate hikes and end their rate hikes by the first half of 2023. The second narrative portends that all the monetary policy tightening will lead to a recession and a collapse in corporate earnings in 2023.
To visually set the table, we lay out a table of outcomes, with green signaling a more positive outcome for markets and red signaling a more negative outcome.
Already, even in December, we are seeing that the narrative on positive performing days is one of investors feeling reinvigorated by the prospects of a policy pivot and dovish Fed. The narrative on those downward-performing days is attributed to the anxiety of fragile corporate earnings with a pending recession around the corner. We believe this back and forth battle will continue into next year.
Setting the table above allows us to try to determine two things. The first is to identify any common influencing variables between the two narratives. The second is to decide which outcomes are more likely.
As to common influencing variables, we feel inflation remains the key. Should inflation continue to decrease, the higher is the likelihood that the Fed can reduce and stop hiking rates. Furthermore, if inflation is declining, the likelihood of a recession is also lower as price stability tends to improve consumer strength and confidence, which are integral to a growing economy. That said, falling inflation does not guarantee that the Fed will end rate hikes or that a recession can be averted. If the inflation does not fall fast enough or is not sizeable enough, this could lead to further hikes and a recession. Ultimately, we are watching a race where investors are hoping that inflation can fall fast enough before the economic data weakens too much.
As for which outcome is most likely, we believe the earliest we will get a hint is after the November CPI report, which is to be released on December 13th. Should investors see a follow-through in falling inflation from the October print that would be the first back-to-back decline in inflation. Although two CPI prints do not set a trend, we believe this is a bellwether that the worst may truly be over. The current consensus view is for November CPI to come in softer, which increases the likelihood of the Fed ending rate hikes with no recession. However, should a recession still persist, the recession will likely settle on the mild side.
The outcomes are unknown. Although we may unknowingly be on the path to recovery, we are in the early stages of trying to confirm the recovery. For this reason, we feel investors should maintain a cautious and balanced approach to investing and wait for the next piece of data to determine whether one should overweight equities. Equipping yourself with an all-season portfolio that allows you to be patient is vital, as the goal should still be one of outperforming the downside and merely participating on any upside.