Market focus shifts from inflation to growth

Economic growth uncertainty come to the forefront

Market volatility increased last week after a slew of weaker-than-expected economic data. U.S. retail sales data for December fell by 1.1% monthly, below the expected 0.8% decline, and at the lowest monthly reading in 2022. This softness occurred during the holiday-spending season and indicated broad-based weakness, including in big-ticket items like auto sales and furniture. This was perhaps the first signal that the U.S. consumer is starting to pull back, feeling the impact of both elevated inflation and potential economic weakness. Investors will now be watching to see if this trend continues into early 2023.

In addition to a weaker consumer, manufacturing data last week disappointed. Industrial production fell by 0.7% monthly in December, below estimates of down 0.1%, also at the lowest reading of 2022. The NY and Philadelphia Fed indexes indicated manufacturing trends contracted in January, both seeing weakness in activity and new orders. This also confirms an ongoing trend of softening demand for goods, as highlighted earlier in the month by weaker-than-expected U.S. ISM manufacturing data.

Overall, economic data has surprised to the downside recently, driving the U.S. economic surprise indexes to their lowest reading since September. While one month does not make a trend, several leading indicators are pointing in the direction of a slowdown in growth ahead. In addition, with headlines around a potential recession, layoffs and political strife, consumers may naturally be pulling back spending heading into the new year.

The ongoing U.S. debt-ceiling debate adds to investor angst

In addition to the economic data, investors faced a myriad of headlines around the ongoing U.S. debt-ceiling debate. Last Thursday, the U.S. officially exceeded its debt limit of 31.4 trillion, and the Treasury began "extraordinary measures," including suspending the sale of certain government securities, to ensure the U.S. meets its obligations.

There has been increased political strife in the U.S., particularly after midterm elections, as both parties ended up with small majorities in Congress (Republicans in the House, and Democrats in the Senate). Nonetheless, there is historical precedent for Congress to come together in a "last hour" debt-ceiling deal, typically with concessions from both sides. Since 1960, the debt ceiling has been raised 78 times in the U.S., including 20 times since 2001 alone2. The Treasury Department has had to use extraordinary measures in six of these standoffs before Congress was able to reach an agreement. Thus, while we would expect some consternation in the interim, ultimately we see the debt-ceiling debate resolving, most likely at the last minute around the July time frame.

From a market perspective, while politics generate substantial headlines, they tend not to be a long-term driver of market performance. In the last several instances of more severe debt-ceiling showdowns, including 1995, 2011 (when S&P downgraded the U.S. credit rating), and 2013, markets were higher in the 12-month period after the debt ceiling was resolved. More broadly, market performance tends to be driven more by economic and earnings fundamentals rather than the political landscape.

Certainly, if the U.S. government were to default on its debt obligations, we would expect significant market disruption, including a loss in confidence in U.S. government bonds and currency, sharply higher yields, and an inability to carry out critical functions like maintaining national defense. However, in our view, this scenario thus far remains a tail risk and not an expected outcome.

Earnings have been mixed, but 2023 estimates are moving lower

Finally, markets have been following earnings this past week for any signals on economic growth. About 11% of S&P 500 companies have reported fourth-quarter earnings so far, and results are mixed. Of these companies, 69% have reported earnings ahead of expectations, which is below the 10-year average of 73%. Earnings for the quarter are expected to fall overall by 4% annually, the first negative growth quarter since 2020. Thus far, we have heard from most of the big banks, and while many are seeing consumer-spending trends hold up, they are also preparing for a slowdown ahead, in part by adding to reserves for potential loan defaults. The first large-cap technology firm to report earnings was Netflix last week. The company missed earnings expectations (driven largely by currency fluctuations), but subscriber growth came in well ahead of expectations, which supported both the stock and the broader technology sector.

As earnings season continues, we would expect companies to remain cautious and continue to reset the bar lower for the quarter and year ahead. Earnings estimates for both first-quarter and full-year 2023 have moved notably lower in recent weeks. First-quarter growth is expected to fall by 1.2%, well below the expectation of 5.9% growth at the end of last quarter. And full-year 2023 estimates now call for 4.0% growth, also meaningfully below the 10.5% forecast as of last September. While earnings revisions may continue to weaken, a first leg lower for 2023 estimates has already occurred.

The good news: Bonds are playing a diversification role

Perhaps one bright spot as we head into 2023 is that bonds have held up better than much of what we saw last year. The U.S. Bloomberg Aggregate Bond Index has increased by over 3.0% so far this year, after falling over 13% last year. Part of this better performance is due to government bond yields moving lower, with the 10-year Treasury yield, for example, falling from 3.80% to around 3.50% this year alone. This move lower likely reflects lower inflationary trends as well as lower economic growth, driving yields lower and prices higher.

More broadly, as the economy potentially enters a mild recession and the Federal Reserve pauses its interest-rate hiking campaign, we would expect bonds to continue to play more of a diversification role in portfolios. In addition, bonds have historically had positive performance in the 12-month period after the Fed pauses rate hikes. And we would expect that as the year progresses, central banks may start to signal rate cuts, which could support bond-price appreciation. Overall, we believe diversified investors will be better rewarded in the year ahead, especially as bond performance improves. While many investors sought shelter in shorter-term bonds and CDs as rates moved rapidly higher, we believe opportunities are forming to complement some of these positions with longer-duration bonds in the year ahead.

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