The labor market kicks off 2023 with a HUGE print… 517,000 new jobs in January! The official US unemployment rate declined to 3.4%, which also happens to be the lowest level EVER recorded. This is truly stunning, folks, especially taking into account the economic context (more on that below). On a sober note, labor force participation increased by a lackluster 0.1% last month, and U6 bucked the general sanguine mood in Laborland, ticking higher to 6.6%. Meanwhile, hourly wages marched higher by 0.4% MoM, and the average American workweek increased to 34.7 hours from 34.4 hours in December. Where did the hiring occur? The top three contributors (our usual suspects) are as follows: leisure and hospitality, business and professional services, and healthcare. Moreover, BLS notes that we are still short by nearly 500,000 workers in the leisure and hospitality space (relative to the pre-pandemic high watermark). The labor market is still far too tight and that tightness only increases the probability for future upward price pressures. In our view, the battle to contain inflation has not been won yet.
At first glance, the economic numbers for January are chilling. Inflation is cooling at both the consumer and producer levels. Meanwhile, economic activity continues to contract. According to the Institute of Supply Management, US manufacturing registered its third consecutive monthly decline in January (each reading was also below 50). Services slumped the most since June of 2020 and the US consumer is beginning to show signs of fatigue. However, preliminary estimates indicate productivity ticked up significantly in the final months of 2022 with labor costs declining, and rate- sensitive sectors appear to be adapting. Homebuyers are beginning to come back into the marketplace; new home sales seem to be tracking for ~600k/ month with mortgage rate volatility moderating substantially over the past few months. Meanwhile, commodity prices have been pressured to the downside of late despite China’s economic reversal and a “softish” (if not stable) US dollar. For those keeping score at home, front month crude oil (WTI) has traded down to roughly $75/ bbl, AND natural gas is hovering around $2.50/ mcf—a familiar level for much of the past decade. Of course, gasoline and diesel prices remain elevated… clearly, the upstream and downstream pictures are a bit different in the energy complex. Regardless, the riddle for our domestic economy is the labor market, which is yet again befuddling Mr. Powell and his counterparts at the Federal Reserve.
While wage pressures have weakened across the spectrum, our view remains that the demand for workers in the US is still too strong for the Fed’s liking (December JOLT’s >11M). Thus, the probability for one or more rate cuts in 2023 is increasingly low. The Fed is more likely to gingerly approach its terminal rate (north of 5% according to our calculus) in small increments of 25 bps. Our base case is that Chairman Powell will likely be afforded the leisure of holding fed funds at their apex— perhaps for a quarter or two—before he is compelled to reduce the benchmark rate. The ultimate goal will be to wring out the excesses of labor demand, while simultaneously muting inflationary pressures, without causing a severe recession or financial meltdown. At this stage of the rate cycle, a carefully calibrated approach to both the short-term fed funds rate and balance sheet unwind will best serve the Federal Reserve (and other central banks around the world). Earnings season rolls on, and we are nearly out of the woods (at least for the next couple of months). What was widely expected to be a horrendous quarterly reporting season for the final quarter of 2022 has turned some heads with positive surprises (notwithstanding yesterday’s afterhours tech wreck). As expected, 2022 operating earnings among S&P 500 companies increased roughly 5% YoY. Interestingly enough 2022 was the most profitable year on record. Furthermore, we expect a similar YoY increase at the operating level in 2023. There is also room for upward revisions to our forecast provided that the Federal Reserve, ECB, BOJ, BOE, etc… don’t “overcook” the financial system and that’s still a big “if.” At this stage of the cycle, bonds seem fairly priced with the US 10-yr treasury hovering around 350 bps and spreads for corporate America’s highest quality issuers swapping hands at ~140 bps above that. We would look for opportunities in the 5.50% to 6% range for investment grade bonds. Equities have enjoyed a strong start to the year and traded within a whisker of our fair value estimate of 4200 (S&P 500) yesterday afternoon. We do not see a reason to revise our fair value estimate for stocks at this time as the key to rerating equities is largely a function of Fed policy (at the moment) and Fed policy is largely predicated on labor demand (again, at the moment). Meanwhile, inflation would have to meaningfully surprise to the upside in order for us to downgrade our view on fixed income.