Macro Cross-Currents Mean We’re Focused on Fundamentals

Fed Likely to Continue 25 bps Rate Hikes, Annual Inflation Retreats Slowly 

January CPI underscored that inflation remains elevated, and while annual inflation continues to retreat, there was a reacceleration in the January monthly CPI change. Total CPI increased +0.5% m/m and Core CPI, which excludes food and energy, increased +0.4% m/m. The current pace of inflation remains elevated compared to the past 30-year monthly average +0.2%. In the past 30 years, the fastest monthly rate of inflation (prior to 2020) occurred in January 1995 when Core CPI accelerated +0.4% – roughly equal to last month’s pace. 

Chart 1: CPI Remains Well-Above Historical Pace¹ 

Today’s pace of inflation will force the Fed to continue implementing restrictive policy. While the Fed has communicated a “higher for longer” monetary policy, it has emphasized that the pace of rate hikes no longer needs to be accelerated and we’ve reached a slower, 25 bps rate hike regime. This slower pace is easier for markets to absorb and for the Fed to analyze its impact. The Fed will likely continue this pace of rate hikes until inflation materially retreats towards their 2% target. 

Improving Input Costs and Economic Stability Supports Corporate Earnings 

As annual inflation slows, consumers and businesses alike benefit from lower costs. Businesses have spent the past 1+ years escalating prices to maintain margins. These higher prices have trickled down to the consumer, but have done little to impact consumer demand – largely due to the $1.7 trillion in excess savings, plus the abundant job openings and higher wages. 

There are nearly two jobs open for every job seeker, and according to ADP, individuals who change jobs have seen wages increase +15%. While we root for the consumer and higher wages, we also root for moderation; the UK just reported the fastest three-month pace of average earnings since records began in 2001, and this creates a challenge for the Bank of England. 

Cost pressures, broadly, are becoming less impactful for businesses. Supply chains are resolved, businesses have implemented pricing power (and continue to do so), a weaker USD supports U.S. multinationals, and there appears to be reacceleration across global economies. 

Chart 2: Positive Eurozone GDP and Weakening USD Supports U.S. Multinationals² 

While the Fed’s goal to crush demand is felt in certain pockets like housing and manufacturing, it’s far from widespread, due to strength in services and the resilient consumer. Consumer strength showed up again this week in better-than-expected January retail sales, which expanded +3% m/m and remain elevated versus last year. 

Opportunities Across Asset Classes 

We’ve said since the fall that it’s entirely possible the economy continues to expand and rates remain elevated – it’s not a zero-sum game. Consensus is now catching on to this reality, referring to it as “no landing” in 2023. It remains uncertain how the yield curve becomes un-inverted, but a more stable Fed policy and macro clarity should eventually alleviate a supply deficit in longer-term bonds. 

Despite the inversion, there are plenty of opportunities to invest in fixed income – credit spreads indicate a healthy debt market. For perspective, a 2-year Treasury bond yields 4.6%. In February 2021, the same bond yielded 0.09%. This is the highest yield curve since right before the Great Financial Crisis. 

Chart 3: Ultra-Safe Treasury Yields Are Much Higher Than in Any Recent History³ 

We think the “earnings recession” narrative is also wrong. Low expectations fail to account for pricing power, consumer resilience, improving cost tailwinds and talented corporate management teams. 

Negative 2022 earnings revisions are too pessimistic. In Q4, with 82% of the S&P 500’s market cap having reported, 4Q22 total EPS is expected to contract -1.7% y/y. However, excluding TECH+, the S&P 500 is tracking 4Q22 EPS to expand +6.5% y/y. The broader cyclicals category is tracking to expand 4Q22 EPS +30% y/y – led by energy and industrials. Discretionary sectors are reporting the biggest earnings surprises, surpassing low expectations on the shoulders of a resilient consumer. On aggregate, companies are beating expectations by +1.8%. 

Amid the low expectations and shifting macro sentiment, we’re staying focused on the investment opportunities and taking what the markets give us. We’re finding opportunities broadly in fixed income and a good environment for active selection within equities. 

Earnings Buoyed by Higher Prices and Consumer Demand 

We think the cross-currents support an environment for active managers and stock selection. The top 3 holdings in the S&P 500 represent 16% of the index and information technology represents nearly 30% of the index. Active management allows greater flexibility to find opportunities. 

Marriott (MAR) beat earnings, highlighted room rates up +13% versus pre-pandemic rates and guided positively with sustained demand from a recovery in business travel and China reopening. So far this year, group travel revenue is pacing +20% above 2022 levels – this includes large gatherings like weddings and conferences. Similarly, Disney (DIS) reported cost-cutting plans and strong parks momentum as it beat earnings expectations. 

Zoetis (ZTS) shared an earnings beat and positive guidance as it strategically invests in its portfolio. PepsiCo (PEP) also reported an earnings and revenue beat, supported by price hikes. Higher prices, despite lower volumes, are supporting company profits. This dynamic contributes to softness across manufacturing industries. Kellogg (K) executed a similar strategy, as higher prices buoyed strong organic growth. Momentum is expected to continue for PepsiCo and Kellogg as prices cover input cost inflation and strong portfolio brands grow organically. 

Still, companies remain conservative in their guidance. We’re closely analyzing the fundamentals, the commentaries and the management execution trends for our portfolio investment decisions. 

Stephanie Link: CNBC TV Schedule 

Sources

1. FactSet (chart). As of February 14, 2023.
2. FactSet (chart). As of February 14, 2023.
3. FactSet (chart). As of February 14, 2023.

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