2023: The Glass is Half Full

The theme of last month's trading could be the theme that prevails in the markets for the next few months. Lower-than-expected inflation numbers combined with stronger-than-expected economic data raised investors’ hopes for a soft landing or only a mild recession. Investor optimism on these developments faded amid cautious remarks from Central Banks.

In the US, the headline inflation rate dropped to +7.1% in November (reported in December) from +7.7% in October (reported in November). This was lower than the expected +7.3%. Canada saw inflation rates of +6.8% for November, down from +6.9% in October. The ISM Services PMI (Purchasing Managers Index), a gauge of the US services sector, rose unexpectedly to +56.5. A reading above 50 indicates activity is expected to expand, while a reading below 50 indicates the activity is anticipated to contract. The unemployment rate in the US at +3.7% and in Canada at +5.1% indicates a marginal increase from previous months, however, remains well below historical levels.

The above data supports the notion that inflation can potentially cool off without harming the economy in a major way. However, authorities at the Federal Reserve continue to exercise caution that lowering defences against inflation prematurely could cause inflation expectations to become entrenched and result in a bigger problem in the coming years. The Federal Open Markets Committee (FOMC), decided to raise policy rates by 50 basis points at the December meeting, and their “Summary of Economic Projections” showed that the participants expect policy rates to rise to 5.25% in 2023 (from +4.50% at present) and stay there for the entire year.

The Fed's major concern is that a strong job market indicates wage inflation, which may continue to fan broad inflationary pressures. The ratio of job openings to unemployed workers has come off its recent highs but remains high in the historical context (See Figure 1). We acknowledge that, at this juncture, the Federal Reserve is right to be cautious in their approach given the strong jobs market; however, we remain optimistic that the wage inflation scare might not turn out to be as bad as expected. The major wage surveys indicate that wage inflation pressures could moderate in the coming months (See Figure 2).

Figure 1: Job markets remain strong from historical perspective

Figure 2: Wage inflation expectations are trending down

Additionally, we are encouraged by the fact that: a) energy prices have dropped from their recent highs; b) the pandemic-induced frictions in supply chains are fading; and c) bottlenecks in the manufacturing supply chain may further ease as the Chinese government softens its stance on the zero-Covid policy. This could mean that inflation surprises to the downside in the coming months, in our view.

Reset of investors’ expectations after corporations release their earnings and outlooks, and the Central Banks maintaining the hawkish tone until inflation numbers decline meaningfully, indicates market volatility might remain elevated. That said, during 2022, investors’ sentiment has moved from ‘irrational exuberance’ to ‘healthy skepticism’ and asset valuations are now more reasonable. This put together with a potential change in the Central Banks’ hawkish rhetoric later in the year means the investing environment for 2023 will present opportunities for long-term investors.

We wish our readers a very Happy New Year 2023!