Stocks opened the first week of 2023 in the green and after a sharp turn higher last Friday following the December nonfarm payrolls report. The S&P 500 Index gained +1.5% to open the new year, while the NASDAQ Composite rose +1.0%. On Friday, the S&P 500 posted its best day of performance since late November after the Bureau of Labor Statistics showed that average hourly earnings rose slower than expected in December. With the market so intently focused on inflation and monetary policy at the moment, the slight nod to cooling labor inflation trends was a welcomed development to ring in the new year. The Dow Jones Industrials Average gained +1.5% last week, with Value outperforming Growth. Communication Services (+3.7%), Materials (+3.5%), and Financials (+3.3%) led stocks higher during the week. Healthcare (-0.2%) and Energy (0.0%) contributed to weighing on the broader stock market.
The 10-year U.S. Treasury yield closed last week at 3.56%, while the 2-year Treasury yield ended at 4.27%. Notably, U.S. Treasury prices were firmer across the curve, with the 10-year yield dropping more than 30 basis points from its December close. The U.S. Dollar Index finished the week generally flat, though the greenback gained ground against a few major currencies earlier in the week. West Texas Intermediate (WTI) crude lost 8.1% to open the first week of 2023. Building recession fears weighed on oil prices, despite more considerable price gains made late in the week. That said, WTI ended the week at $73.67 per barrel, well below its peak of over $120 per barrel in March. Gold finished higher by +2.4%, closing the week at $1871.70.
Despite a solid start to 2023, last week’s stock performance was choppy and driven by traders' reaction and interpretation of two key market dynamics, inflation and recession. Notably, the December ADP private payrolls report showed job growth ahead of consensus estimates and well above November’s private job growth. The +235,000 private payrolls added in December was +90,000 more than expected and +108,000 above November’s pace. Interestingly, the job growth in the private sector came from small and mid-sized companies, particularly in service-related industries. At first blush, the stronger private payrolls report would suggest the labor market is too hot and imply the Federal Reserve has to continue to raise interest rates to cool the economy, therefore increasing the risk the Fed overtightens policy and causes a recession.
However, job gains in the private sector varied by industry last month and showed more fragmentation compared to November. Moreover, December’s ADP report also showed the lowest monthly increase in pay growth since March. Bottom line: The sharp declines seen in private pay gains across leisure/hospitality last month, as well as other industries, quickly refocused traders’ attention to the possibility of cooler inflation pressures ahead.
By the week's close, that sharp decline in wage growth was confirmed in the broader December nonfarm payrolls report. In addition to the +223,000 nonfarm jobs created last month (down from +256,000 in November), average hourly earnings rose +0.3% month-over-month. That was softer than the downwardly revised +0.4% pace in November, which was initially reported at +0.6%. In addition, the unemployment rate dropped to 3.5% in December from 3.6% in November — returning to a half-century low. Bottom line: Job gains in December were healthy and showed the labor market continues to remain resilient despite slowing growth in other areas of the economy. At the same time, wage inflation appears to be moving in the right direction. Combined, investors interpreted the job reports last week as a sign a soft landing is still within the realm of possibility for this year, and stocks reacted accordingly.
Market Conditions May Be Entering a Period of Transition that Require a Disciplined Investment Approach
That said, equity prices may continue to react negatively to data showing recession odds are increasing, or inflation is lingering at higher levels. December’s ISM Services Index fell into contraction for the first time since May 2020. New orders dropped materially versus November, as did the employment component. Firms noted the difficulty in backfilling open roles and, in aggregate, pointed to pulling back on hiring given the economic uncertainties at the start of the year. In addition, high-profile layoff announcements across a few technology and financial firms last week also reinforced the idea the investing environment could remain challenging as more firms contend with slower profit growth this year and the need to balance quickly shifting demand/supply dynamics.
In our view, the market and economy are entering a period of transition at the start of 2023. Economic growth could continue to slow, and stocks could react negatively to incoming data showing weakening trends for a period. This could keep uncertainty high for investors and stocks susceptible to bouts of volatility as long as it is unclear when macroeconomic conditions will stabilize. On the bullish side of the equation, a possible peak in inflation, falling gas prices, stabilizing bond yields, weak investor sentiment (a contrarian signal), and a still strong labor market point to factors that could help mitigate the volatility. On the bearish side of the equation, a Federal Reserve still in rate hiking mode, building recession probabilities, higher bond yields (e.g., competition for stocks), and elevated inflation could limit how far stocks could rally over the near term. Until investors can more confidently look into the future and value assets based on firm growth projections, this transition period increases the risk of making timing errors that often erode long-term investment success when rash decisions are made. We believe following a disciplined investment strategy can help investors avoid such costly mistakes.          
At the start of the year, keep these big-picture themes in mind:
All bear markets have one key dynamic in common — they eventually end. Despite the potential for further headwinds, the market is always looking into the future. Stock and bond prices may begin to recover before it is clear the economy is back on a more sustainable growth trend.
Inflation pressures could steadily moderate through 2023 but remain above Federal Reserve targets. In our view, consumer and producer price inflation should slow as the year unfolds. Tougher year-over-year comparisons, tempered demand (in response to higher interest rates), and easing supply constraints could help curb broader price pressures during the year.
U.S. recession risks should remain elevated through the first half. U.S. GDP could further slow in response to inflation, higher interest rates, and cooling labor trends. However, if the U.S. economy slips into a recession this year, sound consumer and business fundamentals could limit the economic downside.
Prepare portfolios to weather volatility but think longer-term when others may be overly focused on the near term. Investors should continue to lean into areas that reduce portfolio risk, including high-quality stocks/bonds and income-producing investments. However, at some point, investors may want to shift into a more offensive approach when the storm clouds begin to lift. Staying disciplined, avoiding timing mistakes, and making modest tactical adjustments when conditions warrant are strategies that could help investors respond to the shifts in growth and policy we are likely to see throughout 2023.
All Eyes Will be on the December Inflation Data This Week
Turning to the week ahead, all eyes will be on Thursday’s December Consumer Price Index report. December headline CPI is expected to come in flat month-over-month after rising +0.1% in November. According to FactSet estimates, headline CPI is forecast to have cooled to +6.5% year-over-year last month and slower than the +7.1% pace seen in November. Importantly, that would mark the slowest pace since October 2021 and materially lower than the four-decade high of +9.1% set in June. Ex-food and energy, core consumer prices are also believed to have moderated in the final month of 2022 amid easing supply chain pressures. In addition, investors will receive a preliminary look at January Michigan Sentiment on Friday. Here, the inflation component of the survey will likely take center stage and should continue to show higher prices have not become entrenched within consumers’ psyche when looking out over the next year.
Finally, the fourth quarter earnings season kicks off in earnest this week. Analysts have set the bar low for S&P 500 companies in Q4, with aggregate earnings per share expected to decline for the first time since the pandemic.
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