The 2023 Bull Case

Hey everyone,

We all know that the fear of inflation and rising interest rates have led many to believe that 2023 will bring a recession and further contraction in financial markets.

But what if the opposite is true? These short-term rallies may seem like random bouts of strength, but what if they're a sign of something bigger to come?

Based on these questions, we’ll be exploring the bull case for 2023.

Bullish Assumptions

This bull case assumes the Federal Reserve will drive the markets in 2023. For 2022, the market was at the mercy of the Fed and its forward guidance. This'll continue to be the case for 2023.

Therefore, our bull case will be in play if we get any sign of a Fed pivot.

With the next Federal Reserve meeting just days away, let's revisit Powell's messaging from the previous FOMC meeting to decipher how they may react to the market setup. The key questions to ask yourselves are:

• Will they pull rate expectations higher and dissuade the market from pricing in a pivot prematurely?

• Or will they capitulate to market expectations and play into the pivot narrative?

Looking back at the FOMC meeting in December, the Fed cranked up the expected interest rates for 2023 and 2024. The freshest dot plot suggests the Fed sees rates creeping up between 5.1% and 5.4% in 2023, then dipping to a broader range of 3.9% to 4.9% in 2024.

Jerome Powell confesses that the Fed's still finding its footing on when to pump the brakes on rate hikes. However, he's been pretty clear about certain milestones he wants to hit before they think about changing course.

Let's call them "Jay Powell's Pivot Prerequisites", which include tighter financial conditions, a noticeable decrease in non-housing services inflation, and widespread economic weakness.

Let's explore how these prerequisites are already fulfilled. 

Tighter Financial Conditions

When looking into the historical correlations between the 10y and 2y yield rate inversion, the unemployment numbers and the correlation with S&P market tops, we can see that recessions typically materialise between 6-18 months following the second 10y-2y rate inversion and after unemployment rises.

The chart, per ANG Traders, how the 10y-2y is still in its first inversion, and unemployment remains relatively unchanged. However, the pink highlighted areas show how the double inversion occurs months before market tops. That indicates that a recession is only likely in 2024. Here, we need to see the 10y and 2y rise and re-invert while unemployment rises drastically. And if unemployment increases in 2023, the Fed will slow or stop the interest rate hikes, keeping the terminal rate below 5%.

The re-inversion of the yield curve and increasing unemployment will signal that the Fed's tightening has worked, giving them license to pivot.

Over the past year, we've seen the S&P 500 getting beaten down by nearly 15% and the value of the bond market taking a massive hit as interest rates have risen (prices of bonds move inversely to rates). So the Fed's tightening policies have caused some pain in the markets.

So the Fed may be ready to pivot. They can see their impact on markets and will want to stabilise things as best they can.

Inflation Moderation

Inflation in the US peaked in June 2022 and has been trending down for many months. Based on the recent inflation numbers, the annual rate in the US slowed for a sixth straight month to 6.5% in December of 2022, the lowest since October of 2021, in line with market forecasts.

It's unlikely inflation will return to the Fed's target of 2% this year. But, it's equally unlikely the Fed will continue with out-sized hikes this year if inflation is trending down.

As the legendary investor Peter Lynch once said:

So, if we can get a sustained Fed Funds Rate below 5% coupled with clear signs of sustained moderation in inflation during 2023, the economy should hold, and markets should rise accordingly.

Economic Weakness

We view broader-based economic weakness as twofold. On one hand, we’ll look at companies and, on the other, consumers.

Corporate earnings compression

Company valuations and earnings were smashed in 2022. Price/Earnings ratios (a multiple showing the value investors will pay for every $1 of company earnings) were down by nearly 20% in 2022. Essentially, investors diminished the future value of every dollar companies earned.

Opinions of where Earnings will go in 2023 are mixed. Still, the above weakening from 2022 will be a feather in the Fed's cap that their tightening applied the necessary economic pressure to companies.

Drilling down further - Big Tech, the most significant group of companies that drive the value of the S&P 500 (making up more than 25% of the index), contracted by ~35% on average in 2022. At the time of writing:

• Amazon is down 40%

• Meta is down a whopping 57%

• And Apple, Google and Microsoft are all down more than 20%

And the rest of the high-growth tech industry is down 60-80%. Using a war analogy, "The Generals of the Market" have been shot.

To add insult to injury, these companies have been making significant job cuts. In 2022, Amazon, Google and Meta laid off over 10k employees, and even Microsoft plans to cut 10k jobs in March.

Weakening consumer

Consumer spending is the key driver of economic growth and determines the velocity of money flowing through the system. The presence of consumer demand inherently becomes a massive factor in whether markets return to an uptrend.

However, consumers have been smashed coming out of 2022:

• Most workers' wages have failed to keep up with inflation (even with it cooling), eroding the purchasing power of households.

• Increases in essential goods and services prices, like fuel, food and housing, have been relentless, compounding the pressure on consumers' purchasing power.

• Consumers are concerned about their level of savings and have delayed large purchases (think houses, cars etc.) into the future.

• Rising credit and debt have put further financial obligations into consumers' laps.

Powell has to look no further than the plummeting retail sales (down 1.1% in December 2022, the most significant drop in a year) and sky-rocketing credit card debt levels to see that the consumer is more than beaten down.

Significant wounds have been inflicted on both companies and consumers. Only Powell knows how much worse things should get for him to be satisfied.

However, this proves that the Fed's tightening has stopped growth in its tracks, permitting them to pivot.

So… Should we be buying?

Despite our bull case above, keep these three things in mind.

Firstly, we must remember the importance of the Fed maintaining its credibility. If they were to pivot too early and lose their credibility, it could jeopardise the US' position as a financial superpower.

Secondly, echoing Howard Marks, inflation is still at insanely high levels despite inflation tapering down. What will that do to earnings and economic growth in 2023? And how can the Fed be sure it's easing? We know they want to see inflation sustained at their 2% target before they are confident it's under control.

And finally, don't forget about all those systemic risks baked into the market we wrote about last week.

Even if we rally in 2023, there is one question all long-term investors will have to ask themselves: Based on the fundamentals, how likely is it that a relief rally in 2023 will turn into another 10-year up-only market?

Our view? With all the structural imbalances in the market, it’s Mission: Impossible.

That’s all for today. If you found this post insightful, share it with a friend or anyone who might appreciate it.

Thanks for reading,

— Luca