The biggest debate in the market right now is whether 2023 will see a recession or not. Based on that view, one's assessment of risk, discount factor and fair value multiples all change accordingly.
After the soft CPI, by soft we mean by 0.2% as we are still talking headline inflation close to 7%, the market is of the view that the Fed will be able to avoid a hard landing and probably pivot sooner than later. Looking back at the Fed's actions historically, they have never really pivoted unless markets collapsed like we saw in March 2020 or September 2019 when the system broke down and Armageddon was projected.
To assume the Fed is looking just at the Nasdaq or crypto debacle and is ready to pivot to help protect the equity market here is wishful thinking. They cannot move from a tightening stance to a dovish without actually seeing something break per se.
As markets cheer trying to front run the Fed, financial conditions get easier, which defeats the purpose of the Fed to begin with, in effect giving them more justification to keep on going. After the excesses of the past decade and a half, this is part of a healthy long-term correction, call it neutralization, reverting back to some sort of mean. Inflation is close to 6%-7%+ y/y and the Fed cannot risk what happened back in 70s, so their focus is to contain it fast.
It is working as we can see demand is falling across the board and easing global supply chains as demand collapse comes into line with supply in some cases. The demand boost we got post Covid was unparalleled and came at a time when the system was not equipped to cope with such strong demand. Of course, China staying closed and in lockdown, is aiding the macro situation as prices ease across the board.
Technically speaking we are in a recession already as we have seen two consecutive quarters of negative growth in some regions. The world is slowing down and there is no doubt about that. If one were to see freight rates from US and EU to China routes, they have collapsed as there is no demand and inventories built too much too fast now.
Historically if one were to look back at past Fed rate hiking cycles, each time they raised rates this aggressively, the market has seen a recession ensue in the following year.
This period could be compared to 2001 when after the Dot.com collapse the Fed kept raising rates, and even when they started cutting rates by 500 bps in one year, the market fell much more. So, a pivot is not necessarily a good thing and it all depends on how it happens and what the backdrop is. Consensus is assuming 5% growth for 2023, which seems at odds with all the data that is being released currently as Wall Street is too high on consensus numbers.
Companies will face lower margins as top line recedes but labor and cost inflation remain sticky. Looking back at historical recessions, one can easily see earnings fall by 10%-15% yoy, which would mean the S&P 500 has not found a floor yet it would seem.
A big part of the call on whether or not we see a recession depends on the price of oil. Despite most believing that Biden's release of SPR would do more harm than good, the fact of the matter is that oil prices are down 40%+ since the highs seen in May. Of course, it was timed with a slowing economy which helped a lot more.
A big part of the rally in oil had been because OPEC had been terribly slow to bring back the 10 mbpd of oil they took off the market back in March 2020. As the world reopened, demand surged, and they deliberately held supply back which saw prices rally before the Ukraine war even. Today despite all the talk about Russian barrels being lost, just the flow of oil changed, not the amount per se. In fact Oil price is now flat for the year! This is confusing many and mostly OPEC who are now contemplating what to do.
Yesterday we heard rumors that OPEC+ was looking to increase production by 500kbpd in December, which took the oil price down by another 5%, which was later denied and saw it rally back up. But oil prices have been falling for weeks as physical spreads have moved into contango. Oil is still trading about $20/bbl. higher than pre-Covid levels but demand is much lower since then! If OPEC were to focus too much just on price and cut to "protect" these prices, then a recession is almost inevitable and a harsh one too!
The longer the prices remain higher, the economy will be in stagflation for years and no central bank will be able to do QE as inflation is the nemesis that never existed before. Their hands are tied and the market better accept this sooner than mistake this to be another "normal" cycle... the Fed put is a heck of a lot lower.