Q1-2023 (Published: Feb 2023)

Opening Remarks:

In our Economic Outlook post in August 2022, we forecasted that the markets will be on a downward trajectory for the remainder of 2022 with occasional bear market rallies, which has proven to be right up until this point. But will the trend continue into the first half of 2023 as we had forecasted?

Although we continue to stand by our earlier forecast, the new data paints a conflicting picture. Data released in January 2023 indicated that inflation was coming under control. This, accompanied by strong earnings reports by some companies, better-than-expected GDP results, and a softer tone from Jerome Powel, stoked optimism among investors. As a result, “soft landing” and even “no landing” scenarios gained traction and S&P 500 rose by 6.18% during the month of January 2023.

Subsequently, in February 2023, the markets lost most of the gains in January with sentiments pointing in the direction of more losses. See below for the economic data made available during the first two months of the year. Overall, inflation proves to be stickier than anticipated, which is consistent with the experience of countries that grappled with inflation. In our opinion, some market participants don’t quite comprehend the difficulties in lowering inflation to the Fed’s expectation of 2% and the damages that it might inflict on the economy and employment. At the same time, there are investors who acknowledge that inflation is hard to tame and requires demand destruction, but they don’t see it happening in the current political climate. In other words, even though the Fed and the government understand the right path forward (i.e. increasing interest rates), they might not go through with it for political reasons. In such a scenario, stock markets will rally again and inflation will remain rampant. Although this is not an outlandish scenario given the extreme partisanship in US politics, given the seriousness of the current situation and the severity of consequences, the likelihood of choosing the right path forward is higher. As such, at GGC, we believe that the US will make the right long-term policy decisions, even if they will cause short-term pain.

What should we expect in the coming months?

Starting from March 2023, we should start feeling the impact of rate hikes. Note that Quantitative Tightening (QT) is in progress which will augment the impact of the monetary policy, but QT is moving at a very slow pace. So we believe that S&P500 will oscillate around 4000 until the cumulative impact of the monetary policy and QT combined with an external shock hit the markets. Is it possible that the external shock never happens? Yes, it is, but unlikely. Do we know what the shock will be? No. It’s very hard to forecast that. Can China come to the rescue of the global economy? Yes, that is possible, but China has its own issues, so it is unlikely that China can do much. Moreover, as it relates to international trade, China was pretty open and functioning, so the reopening will not have a significant impact.

Should we expect a recession or a significant drop in the markets? No. We estimate a correction of 5%, with S&P going as low as 3,800. Of course, it is possible that markets drop further in the case of a significant adverse event. In fact, it is possible that market participants confuse the shock we mentioned above with some sort of significant event, resulting in a temporary drop below our forecasted levels.
In conclusion, we don’t believe markets will crash, mostly because what is driving the changes is a semi-controlled rate hike by the Fed. In fact, so far the increases have been reasonable and necessary so that the money is not almost free anymore. It is true that interest rates stifle growth, but interest rates at the current levels are quite normal and if anything, they will cause normalization of the markets, allowing better businesses to survive and enjoy the benefits of a market that has been cleansed of incompetent businesses.

Indicator	Result	Period	Impact/Significance/Discussion
Federal Funds Rate (FOMC)	25 bps increase 4.5% to 4.75%	Feb 1, 2023	As expected, the Fed increased the rates by 25 bps. During the Q&A session after the press release, Chairman Powell indicated that they will continue with their 'data-dependant approach'. Moreover, Jay Powell indicated that the committee stands by its economic forecast. Fed's Summary of Economic Projection
ISM Manufacturing PMI (Institute for Supply Management)	47.7%	Feb 2023	The February Manufacturing PMI® registered 47.7 percent, 0.3 percentage point higher than the 47.4 percent recorded in January. February 2023 was the third consecutive month of contraction after the 30-month period of expansion.
ISM Services PMI (Institute for Supply Management)	55.1%	Feb 2023	Business Activity Index at 56.3% New Orders Index at 62.6% Employment Index at 54% Supplier Deliveries Index at 47.6% The sector has grown in 32 of the last 33 months, with the lone contraction in December 2022 (at 49.2%).
Employment Situation Report (BLS - Bureau of Labor Statistics)	Unemployment rate at 3.6%	Feb 2023	Total nonfarm payroll employment rose by 311,000 in February, and the unemployment rate edged up to 3.6 percent.
CPI (BLS - Bureau of Labor Statistics)	6.0% y/y 0.4% m/m	Feb 2023	The Consumer Price Index for All Urban Consumers (CPI-U) rose 0.4 percent in February on a seasonally adjusted basis, after increasing 0.5 percent in January. Over the last 12 months, the all items index increased 6.0 percent before seasonal adjustment.
PCE (BEA - Bureau of Economic Analysis)	PCE Increased 0.6% m/m PCE Excluding food & energy: increased 0.6%	Jan 2023	Why PCE Matters? Similar to CPI, PCE is a measure of inflation. The Fed pays special attention to PCE (especially: "Core PCE"; i.e., PCE, excluding food and energy). M/M "PCE" (Headline PCE) change: Jan'23: +0.6% | Dec'22: +0.2% | Nov'22: +0.2% M/M "Core PCE" (Core PCE) change: Jan'23: +0.6% | Dec'22: +0.4% | Nov'22: +0.2% Y/Y Headline PCE: Jan'23: +5.4% | Dec'22: +5.3% | Nov'22: +5.6% Y/Y Core PCE: Jan'23: +4.7% | Dec'22: +4.6% | Nov'22: +4.8% Another measure that is published with PCE is DPI (Disposable Personal Income) Personal income increased $131.1 billion (0.6 percent) in January Disposable personal income (DPI) increased $387.4 billion (2.0 percent)
PPI (BLS - Bureau of Labor Statistics)	0.1% decrease m/m	Feb 2023	What is PPI: The Producer Price Index (PPI) program measures the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services. It matters because it might signal the upcoming changes in CPI and PCE. The Producer Price Index for Final Demand decreased 0.1 percent in February. Final demand prices advanced 0.3 percent in January and declined 0.2 percent in December 2022. On an unadjusted basis, the final demand index rose 4.6 percent for the 12 months ended in February 2023. In February, the decline in the final demand index was led by prices for final demand goods, which fell 0.2 percent. The index for final demand services edged down 0.1 percent.

In addition to the indicators above, we also track the monetary base which shows gradual, but slow decline as the Fed continues with QT.

March 2023 Update:

As we expected, during March, we witnessed a few casualties of the rapid increase in the interest rates, most notably Silicon Valley Bank and Signature Bank. Another bank impacted was First Republic Bank, but a consortium of larger banks provided equity injection to the troubled bank. This move, led by Jamie Dimon, the CEO of JP Morgan, was similar to what JP Morgan did over a century ago.

Due to the banking issues, the market was volatile during March. But in the end, better-than-expected core-PCE results, combined with lower inflation expectations (according to the University of Michigan survey) resulted in a rebound in stock market prices.

The quick recovery of the stock prices reveals two underlying facts: 1) there is still a considerable amount of optimism in the market, and 2) there is a lot of cash on the sidelines to be deployed. For these two reasons, we don’t really expect an imminent crash in the market.