February 2023

Inflation continues to show signs of cooling, but the hot labor market presents a challenge for the Fed

Markets were laser focused on the January CPI report that showed inflation rose 0.5% month-over-month (M/M) or 6.4% year-over-year (Y/Y). Core CPI increased 0.4% in January and 5.6% over the past year. Rising shelter costs accounted for about half the monthly increase; shelter costs rose 0.7% in January while energy jumped 2% and food costs increased 0.5%. “Super core” services inflation, which excludes food, energy, and shelter, rose 0.2% M/M and 4% Y/Y. Inflation is trending down, but it remains sticky, and this report likely keeps additional Fed rate hikes in play for a few more months.

The January employment report smashed expectations with 517,000 new jobs created and the unemployment rate falling to 3.4%, which is its lowest level since May 1969. Estimates were for 187,000 new jobs and an unemployment rate of 3.6%. More workers entered the labor force last month, as the labor participation rate edged up to 62.4%, while the broader U6 measure of unemployment was 6.6%. Wages also posted solid gains for the month, as average hourly earnings increased 0.3% (in-line with market estimates) and 4.4% from a year ago.

The Federal Reserve raised rates by another 25 basis points at its February 1st meeting, but all projections, including the terminal rate,  were unchanged from December. There continues to be a large disconnect between market and Fed terminal rate expectations, and risk assets have rallied sharply over the past month in anticipation of the Fed nearing the end of its current rate hiking cycle. Chairman Jerome Powell indicated that disinflationary pressures are starting to take hold. A “soft landing” scenario seems increasingly likely.

Retail sales and durable goods orders show weakness in consumers and business spending

U.S. Retail Sales declined by 1.1% in December after consumer fears of high inflation and a slowing economy made for a lackluster holiday shopping season. While December sales fell more than consensus expectations, November sales were also revised lower from –0.6% to –1.0% M/M. Retail sales during the holidays came in lighter than expected but still grew 6% Y/Y.  Durable goods orders jumped 5.6% in December, well ahead of the market’s 2.4% expectation. However, orders fell 0.1% when excluding transportation, as demand for Boeing passenger planes helped drive the headline number upwards. This surge in transportation orders masked weakness in business spending.

Source: Bureau of Labor Statistics, CNBC

Manufacturing = contraction; services = expansion

U.S. manufacturing contracted further in January as higher interest rates stifled demand for goods, but factories did not appear to be laying off workers in large numbers. The ISM Manufacturing PMI fell for the third straight month in January, falling from 48.4 to 47.4. Production and new orders were particularly weak in January while employment held steady. The U.S. service sector rebounded sharply in January, as the ISM Services PMI jumped from 49.2 in December to 55.2 in January. New orders, production, and employment all rose while prices fell slightly.

Credit has never posted consecutive years of negative returns; Are PE write-downs starting?

Investor sentiment changed dramatically early this year amid a better-than-feared Q4 earnings season and expectations of a less-hawkish Federal Reserve as inflationary pressures start to ease. While sentiment could certainly shift back towards negative, credit markets enter 2023 well positioned to absorb some bad news and potentially generate attractive total returns this year. Since the inception of high-yield and floating rate loan benchmarks, both credit sectors have never posted consecutive calendar years of negative returns. Spreads/yields will likely continue to be volatile, but credit offers sufficient carry/yield and shorter duration properties to help offset the risk associated with higher interest rates. We continue to believe that the Fed is nearing the end of its interest rate hike cycle.

Source: Bloomberg, Franklin Square

A significant disconnect between public and private market valuations remains in place, although the gap has narrowed with the January rally in public markets. Pressure is mounting on the valuations of private equity-backed companies, and write-downs are likely to impact the frothier parts of the market, such as VC-backed technology starts, first. Public stock volatility, rising interest rates, inflation, and slower growth are straining many corporate balance sheets, both in public and private markets. However, many private equity firms have yet to reflect how those pressures are hitting their bottom lines. Secondary market pricing has already shown a gap in valuations between venture and buyout assets in the U.S. Average pricing for secondary stakes in U.S. VC assets fell to 68% of net asset value in 2022 from 88% in 2021, according to a report from investment bank Jefferies Financial Group. Average pricing for U.S. buyout assets fell to 87% of NAV in 2022 from 97% in 2021.

Eurozone ekes out positive growth in Q4, but recession expected in 2023; BOJ cuts its economic outlook

The start of 2023 saw eurozone business activity rise marginally to a tentative return to growth after six successive months of decline, according to flash PMI data from S&P Global. The Composite PMI hit a seven-month high at 50.2 while the Services PMI hit a six-month high at 50.7. Manufacturing also hit a five-month high but remains in contraction territory at 48.8. A steadying of the eurozone economy at the start of the years adds to evidence that the region might escape a deep recession.  The eurozone posted surprise GDP growth of 0.1% quarter-over-quarter (Q/Q) in Q4, ahead of the -0.1% estimate. GDP grew 1.9% Y/Y but is expected to slow in 2023.

Japan’s government cut its monthly economic assessment in January for the first time in 11 months, as trade weakened due to a global economic slowdown.  Their latest report said that while parts of the economy are showing weakness, the overall economy is strengthening moderately. Japan also downgraded their views on exports, imports, and bankruptcies. The government also remained cautious over downside risks from the global economic slowdown amid monetary tightening, inflation, and financial market fluctuations. One positive highlight was the robust level of domestic/private consumption.

China’s reopening may be the wild card for 2023 global growth

China’s Q4 GDP report was better than expected with 2.9% growth reported versus the estimate of 1.8%. For 2022, the Chinese economy grew 3%, slightly ahead of the 2.8% forecast. While China’s economy did outperform downwardly revised expectations, GDP was well below the government’s 5.5% growth target. Economic data showed broad weakness in 2022, but retail sales, industrial production, and fixed asset investment were above forecasts in December. Growth has clearly slowed across China due to their zero COVID policy, but restrictions have been removed and the PBOC has provided significant stimulus. China will announce it 2023 growth target in March, and they should be concerned about slowing global growth and weak external demand.

China’s factory activity bounced back in January and expanded for the first time since September. The official manufacturing PMI rose to 50.1 in January, above the 50-point mark that separates growth from contraction and December’s reading of 47. The official non-manufacturing PMI rose to 54.4, the highest level since June 2022. It was a sharp improvement from a reading of 41.6 from the previous month, backed by a strong recovery in services and construction activities.

Source: Wind, National Bureau of Statistics

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