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Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.

Inflation and Fed policy remain top-of-mind for investors, and we received updates on both this week. The November Consumer Price Index (CPI) report contained a second consecutive month of promise (0.2% m/m core CPI), particularly in terms of goods inflation. It is becoming clear that core goods prices are on a good trajectory, influenced by improved supply and weakened demand across the manufacturing sector, along with weaker commodity prices since mid-year. Services inflation is proving a little more sticky, influenced by the tight labor market. There are currently an estimated 1.7 job openings for every unemployed person, putting upward pressure on wages (in order for companies to attract and retain employees) – which in turn puts upward pressure on prices to maintain profitability. These are the biggest questions on inflation in our view – services inflation and wage growth. We do expect a moderation in both over the next year as the economy weakens, but the path is unlikely to be quick or smooth.

This is filtering into Fed projections, which came with a more hawkish tone than market expectations in Wednesday’s FOMC meeting. Fed Chairman Jerome Powell acknowledged the consecutive months of improvement in CPI, but noted that there is still a long way to go in order to make sure inflation comes down to a reasonable level. The Fed’s projected peak 2023 fed funds rate moved higher to 5.1-5.4% with no cuts in 2023. This is relative to market-implied expectations of a ~4.8% peak and 50 basis points (bps) of cuts in the back half of next year. It could be that the Fed is simply talking tough in order to keep a lid on financial conditions – i.e. an equity market surging higher is inflationary. But we do believe that the Fed is likely to err on the side of caution (justifiably) in order to kill high inflation and minimize the risk of a prolonged (and more damaging) period of sustained high inflation.

We believe that the Fed will be successful in bringing inflation lower, but 425bps of tightening this year (a negative influence on demand) will act with a lag on the economy – and investor focus will transition from inflation toward how much pain will be inflicted on the economy. We expect a mild recession in 2023 and are not yet convinced that equity markets have fully priced that in yet. For example, bottom-up earnings estimates are still too high in our view. That said, we also believe that a lot of negative news has been priced in already. Recessionary bear markets contract 33% over 13 months on average, and we have seen a 25% pullback over 11 months up to this point.

Technically, there have been some positives over recent months suggesting the market is attempting to turn. But ultimately, we need to see the series of lower highs and lower lows come to an end. The S&P 500 is currently overbought and pulling back from 200-day moving average resistance once again. Overall, we expect at least more time left in this bear market and believe the S&P 500 could be set for a 3700-4300 range over the next several months. Thus, we do not feel the need to chase the rally periods and recommend using the weak periods as opportunity to accumulate favored stocks for the next bull market.

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