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Weekly Recap:

Market remained on edge last week as investors digested the unfolding drama in the financial sector. The week began with several announcements aimed at staving off contagion from Silicon Valley Bank and Signature Bank. By Tuesday, however, it was clear that Credit Suisse, the giant Swiss bank with more than $500 billion in assets, was also facing a crisis of confidence amongst clients and counterparties and would not survive intact. Swiss officials raced to find a solution, but the sheer size of the institution meant there was really only one viable option – a shotgun marriage with longtime rival UBS, which was finally arranged on Sunday the 19th.

Domestic equity markets were mixed, with noncyclical large caps posting modest gains. Most cyclicals (financials, energy, materials, and industrials) and small caps were lower, as investors priced in a higher chance of a US recession.

Bond markets rallied for the second week in a row, as yields fell on safe haven demand. High yield corporates were the exception thanks to rapidly widening credit spreads, consistent with an increase in perceived recession risk.

Economic data was mixed last week. Core CPI (+0.5% m/m) came in slightly higher than expected, but Core PPI was flat m/m in a sign that upstream price pressures continue to moderate. Housing showed renewed signs of activity, with residential building permits (1.52mn) and housing starts (1.45mn) both rising sharply m/m. Initial jobless claims fell back below 200k in a clear sign of labor market strength. However, the Conference Board’s Leading Economic Index (LEI) fell sequentially for the 11th month in a row, and several gauges of manufacturing activity (Philly Fed, New York Fed, and Empire Manufacturing) remain in contraction territory.

Albion’s “Four Pillars”:

Economy & Earnings

The US economy enjoyed a strong second half of 2022, but corporate operating margins have been gradually falling as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 17x is above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. The equity risk premium has expanded slightly over the past two weeks on concerns regarding the financial system.

Interest Rates

Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in one more 25bp hike in March, followed by a pause and then several rate cuts in the back half of the year.

Inflation

After reaching 40yr highs in spring of 2022, inflation moderated in the second half of the year. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged. Real-time inflation data ticked higher sequentially in February of 2023.

Weekly Recap:

Last week was calm at the start, with rates relatively stable through Wednesday’s close while equities were only slightly lower. That all changed on Thursday, however, as market participants watched the rapid descent of Silicon Valley Bank into receivership. In the span of barely 24 hours, investors went from worrying about inflation and Fed policy to wondering how many small technology firms might suddenly have liquidity challenges and grappling with the possibility of a wider crisis of confidence within the banking system.

Asset price changes were consistent with a broad-based increase in risk aversion:

• Treasuries rallied
• Credit spreads widened
• Commodities fell
• Equity prices moved lower

Predictably, financials were the worst performing sector, while defensives such as staples and utilities were less impacted. Small caps underperformed, as one might expect given their greater dependency on banks for liquidity and financing.

This episode has radically altered investor expectations regarding the forward path of Fed policy, under the assumption that the Fed is less likely to further tighten policy if the banking system appears wobbly. One week ago, futures markets were pricing in 3 or 4 additional rate hikes in 2023, and no rate cuts prior to year-end. Futures now suggest that the Fed will hike 25bp in March and then stop, and that as many as three rate cuts could occur by December. As a result, the implied year-end Fed Funds rate has fallen nearly 150bp, from 5.56% to 4.10%, in just three days.

Albion’s “Four Pillars”:

Economy & Earnings

The US economy enjoyed a strong second half of 2022, but corporate operating margins have been gradually falling as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 18x is above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.

Interest Rates

Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in one more 25bp hike in March, followed by a pause and then several rate cuts in the back half of the year.

Inflation

After reaching 40yr highs in spring of 2022, inflation moderated in the second half of the year. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged. Real-time inflation data ticked higher sequentially in February.

February 2023 Recap

Inflation

Data released in February indicated a mild reacceleration of inflation during the month of January. Core CPI was +0.4% m/m for the second straight month, while Core PPI surprised to the upside at +0.5% m/m, accelerating sequentially by 20bp. Finally, the m/m change in the Core CPE Deflator (the Fed’s preferred inflation gauge) rose 20bp to +0.6%. In addition, the December prints for all three metrics were revised higher relative to their original release.

Monetary Policy

As expected, the FOMC raised overnight interest rates by 25bp on February 1st. At the time, futures markets implied that only one more 25bp rate hike was expected at the March FOMC meeting before the Fed would pause and adopt a more neutral policy stance. However, after a very strong Nonfarm Payroll report (+517k) on February 3rd, and the aforementioned uptick in inflation data, futures markets finished the month with three additional 25bp rate hikes priced in before a pause, and implied virtually no chance of any rate cuts before year-end.

Economy

Incoming data in February suggests that the US economy is experiencing solid growth so far this year. As of month-end, the Atlanta Fed’s GDPNow estimates an annualized real time GDP growth rate of +2.8%. Housing showed signs of stabilization in February, the labor market remains very strong, and several gauges of manufacturing activity moved from contraction to expansion. Consumer confidence is mixed, with signs of relief regarding inflation tempered by some anxiety about future prospects for the economy.

Bond Market

After a strong rally in January, bonds reversed course in February. Rates rose across the curve as investors recalibrated their expectations for inflation and Fed policy, pushing bond lower. The move higher in rates was especially pronounced in the front end, widening the Treasury yield curve inversion. Nearly 90% of curve points were inverted at month-end (i.e., shorter-term yields higher than longer-term yields), with the much-watched 3m/10y point inverted by 85bp, the deepest since late 1981. Credit spreads were largely stable on the month, so municipal and corporate bond prices declined roughly in line with Treasuries.

Stock Market

Equities were also stung by the February reversal in the inflation trend, as rising bond yields pushed up discount rates, causing mild P/E multiple compression. Q4 earnings season was also not especially kind to stockholders. Many companies issued conservative guidance for 2023, particularly regarding operating margins thanks to labor and input cost pressures, causing analysts to lower their forward earnings estimates.

Albion’s “Four Pillars”

Economy & Earnings

The US economy enjoyed a strong second half of 2022, but corporate operating margins have been gradually falling as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 18x is above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.

Interest Rates

Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in a total of four 25bp hikes in 2023, with a “terminal” Fed Funds policy rate slightly above 5% for this cycle.

Inflation

After reaching 40yr highs in spring of 2022, inflation moderated in the second half of the year. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged. Real-time inflation data ticked higher sequentially in February.

Weekly Recap

The holiday-shortened week was a tough one for financial markets thanks to recent trends in inflation, which does not appear to be cooling as quickly as market participants had hoped. The January print of US PCE (personal consumption expenditures, the Fed’s preferred inflation gauge), was higher than expected and showed sequential increases across the board:

• Headline PCE Deflator: +0.6% m/m, +5.4% y/y
• Core PCE Deflator: +0.4% m/m, +4.7% y/y

In response, rates continued to rise across the curve, particularly in the front end as the yield curve inversion deepened. Futures markets are now pricing in 25bp rate hikes at each of the next three FOMC meetings (March, May, and June), with very low odds of any rate cuts happening before the end of the year. Rising rates in February have erased most of the gains enjoyed by bond investors during January, leaving fixed income close to flat on the year.

Equities were not spared the selling pressure either. The S&P 500 was down for the 3rd week in a row, while the more rate-sensitive Nasdaq underperformed on weakness in longer-duration technology stocks.

Other economic data released last week showed a resilient US economy. Initial jobless claims remain below 200k/week, S&P Global’s Composite PMI rebounded into expansion territory (as did several regional Fed surveys), new home sales rose for the 2nd straight month, and the University of Michigan’s consumer sentiment index rose slightly in the final February print, with a notable gain in the future expectations component.

Albion’s “Four Pillars”

Economy & Earnings

The US economy enjoyed a strong second half of 2022, but corporate operating margins have been gradually falling as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 18x is above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.

Interest Rates

Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in a total of four 25bp hikes in 2023, with a “terminal” Fed Funds policy rate slightly above 5% for this cycle.

Inflation

After reaching 40yr highs in spring of 2022, inflation moderated in the second half of the year. Headline inflation eased over the summer on falling energy prices, and core inflation followed suit in Q4. Goods inflation has fallen due to softening demand and excess inventory, while heavily lagged housing data is one factor keeping reported services inflation elevated, at least for now.

Weekly Recap

It was a mixed bag for financial markets last week after fresh US inflation data for January came in somewhat higher than expected. Core CPI rose very slightly on a m/m basis, the second such sequential increase, while the m/m change in Core PPI rose for the 4th consecutive time. See the Chart of the Week for a time series.

The moderate uptick in real time inflation data coupled with the extremely strong January NFP report had market participants recalibrating their Fed expectations. After the February 1st rate hike of 25bp, futures markets suggested that only one more such hike would like occur at the March meeting, after which the Fed was expected to pause. Fast forward just two weeks, and futures now suggest that three more 25bp hikes are likely, one in each of March, May, and June. As a result of the shift in expectations for the Fed, bond investors saw rising yields and lower prices for the second week in a row, particularly towards the front end of the curve.

Equities were mixed last week. The Nasdaq outperformed, a rare occurrence with rising rates. Meanwhile, falling oil prices pulled down the energy sector, keeping the Dow flat and pushing the S&P slightly into the red. International markets were mixed as well, with weakness in Chinese stocks pulling E/M benchmarks lower.

Other economic data released last week showed stabilization in housing starts and building permits, and perhaps some cautious optimism (or at least less pessimism) on the part of homebuilders. Unemployment claims remain low, most gauges of manufacturing activity remain weak, and strong retail sales from January suggest the US consumer remains resilient despite inflation.

Albion’s “Four Pillars”

Economy & Earnings

The US economy enjoyed a strong second half of 2022, but corporate operating margins have been gradually falling as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 18x is above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.

Interest Rates

Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in a total of four 25bp hikes in 2023, with a “terminal” Fed Funds policy rate slightly above 5% for this cycle.

Inflation

After reaching 40yr highs in spring of 2022, inflation moderated in the second half of the year. Headline inflation eased over the summer on falling energy prices, and core inflation followed suit in Q4. Goods inflation has fallen due to softening demand and excess inventory, while heavily lagged housing data is one factor keeping reported services inflation elevated, at least for now.

Weekly Recap:

Financial markets had a challenging week after the previous Friday’s blowout Nonfarm Payroll report (+517k) caused investors to recalibrate their expectations for addition rate hikes this year. Going into the report on the morning of February 3rd, futures markets were pricing in just one additional 25bp hike at the March meeting. Afterwards, investors immediately priced in another 25bp hike at the May meeting, as well as roughly 50/50 odds of one more over the summer.

Bond yields rose across the curve in response, making it a challenging week for fixed income. Credit spreads were largely stable, resulting in similar performance between Treasuries and US corporates.

Equity markets responded in predicable fashion. The prospect of additional rate hikes in combination with somewhat lackluster Q4 earnings (in the aggregate, at least) sent stock prices lower over the course of last week, with more rate-sensitive growth sectors feeling the greatest selling pressure.

In the aftermath of the previous Friday’s NFP report, incoming economic data was fairly sparse last week. Initial jobless claims remained below 200k for the 4th straight week. Meanwhile, the University of Michigan’s Consumer Sentiment gauge rose to 66.4 in the preliminary February print (from 64.9 in January), with the gains driven by improvements in the current conditions component. Long term (5-10y) consumer inflation expectations remain well anchored at 2.9%.

Albion’s “Four Pillars”:

Economy & Earnings

The US economy enjoyed a strong second half of 2022, but corporate operating margins have been gradually falling as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 18x is above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.

Interest Rates

Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in a total of three 25bp hikes in 2023, with a “terminal” Fed Funds policy rate of roughly 5% for this cycle.

Inflation

After reaching 40yr highs in spring of 2022, inflation has begun to moderate in recent months. Headline inflation eased over the summer on falling energy prices, and core inflation followed suit in Q4. Goods inflation has fallen due to softening demand and excess inventory, while heavily lagged housing data is one factor keeping reported services inflation elevated, at least for now.

Weekly Recap:

US equities had another strong week, particularly the Nasdaq which has benefitted from a sharp rebound in mega-cap technology stocks. After posting a 4.3% return last week, the Nasdaq is already up more than 11% so far in 2023. From a sector standpoint, 2023 returns have been clustered by style: growth sectors (tech, consumer discretionary, and comms) have outperformed, while traditional defensives (utilities, staples, and healthcare) have been used as a source of funds and have underperformed as investors have looked to add risk.

Bond markets were relatively quiet last week. The Treasury yield curve pivoted slightly, with short rates rising a few basis points while yields in the belly and long end fell by a similar amount. Credit spreads continued their slow grind tighter, pushing corporate bond prices higher. IG spreads have now tightened by roughly 40bp since peaking above 150bp in October of last year (see the Chart of the Week for a time series).

Economic data released last week reinforced existing trends: slowing manufacturing activity, moderating inflation, strong labor markets, and a resilient consumer.

• S&P’s US Mfg (46.8) and Svcs (46.6) PMIs remain in contraction territory
• Fed surveys (Philly, KC, Richmond, and Chicago) also remain in contraction
• Headline (+0.1% m/m) and core (+0.3% m/m) PCE deflators were modest
• Initial jobless claims fell to 186k, the lowest level since April of 2022
• U of M consumer sentiment (64.9) was revised slightly higher for January
• U of M inflation expectations were revised lower (1y = 3.9%; 5-10y = 2.9%)

Albion’s “Four Pillars”:

Economy & Earnings

The US economy enjoyed a strong second half of 2022, but corporate operating margins have been gradually falling as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 18x is slightly above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.

Interest Rates

Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in two additional 25bp hikes in 2023, with a “terminal” Fed Funds rate slightly below 5% for this cycle.

Inflation

After reaching 40yr highs in spring of 2022, inflation has begun to moderate in recent months. Headline inflation eased over the summer on falling energy prices, and core inflation followed suit in Q4. Goods inflation has fallen due to softening demand and excess inventory, while heavily lagged housing data is one factor keeping reported services inflation elevated, at least for now.

Weekly Recap:

Risk assets were mixed in the holiday-shortened week as a raft of softening economic data renewed concerns about a US recession:

• Retail Sales fell 1.1% in December, below consensus estimates
• US Industrial Production fell 0.7% in December, also below consensus
• US Capacity Utilization dropped to 78.8%, the lowest level in 12 months
• Empire Manufacturing (-32.9) fell to its lowest level since May of 2020
• US housing starts (-1.4%) and residential building permits (-1.6%) fell in December
• The NAHB Housing Market Index (35) remains deeply in contraction territory

Amid these signs of a slowing economy, inflation pressures continue to ease despite an extremely strong labor market. Producer Price Inflation (PPI) was -0.5% m/m in December and fell to +6.2% y/y, while Core PPI (ex food & energy) was just +0.1% m/m and dropped to +5.5% y/y. Meanwhile, initial jobless claims (a leading labor market indicator) fell to 190k, the first sub-200k print since September.

Bonds were mostly better bid on the soft economic data, with Treasury yields falling in the front end and belly, while IG credit spreads were stable. High yield spreads widened on the uptick in risk aversion.

Stocks were mixed: large cap tech continued its early-2023 run of outperformance thanks to falling discount rates, while cyclicals (ex energy) and small caps were mostly lower. International stocks outperformed the US yet again, continuing another early-2023 trend. Chinese equities posted their 4th straight week of gains even as a Covid wave has infected 80% of the population by some reports, leaving the MSCI China Index up 13.85% YTD.

Albion’s “Four Pillars”:

Economy & Earnings

US GDP rebounded to +2.6% in Q3 after falling in 1H22, and corporate operating margins remain solid at ~12% on the S&P 500. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 17x is slightly above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.

Interest Rates

Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in two additional 25bp hikes in 2023, with a “terminal” Fed Funds rate slightly below 5% for this cycle.

Inflation

After reaching 40yr highs in spring of 2022, inflation has begun to moderate in recent months. Headline inflation eased over the summer on falling energy prices, and core inflation followed suit in Q4. Goods inflation has fallen due to softening demand and excess inventory, while heavily lagged housing data is one factor keeping reported services inflation elevated, at least for now

Weekly Recap

Steadily moderating inflation data helped push rates lower across the curve last week, which in turn drove P/E multiple expansion in stocks. CPI data for December was in line with consensus expectations across the board:

• Headline CPI declined 0.1% sequentially and fell to 6.5% y/y
• Core (ex food & energy) CPI was +0.3% m/m and fell to 5.7% y/y

Rates moved lower as the curve became slightly more inverted, pushing Treasury and other bond prices higher. After an extremely challenging 2022, fixed income is off to a strong start in 2023, with yields remaining attractive even as solid price gains have been realized in the first two weeks of the year.

Equities followed suit as falling risk-free rates enabled P/E multiple expansion. Longer-duration growth stocks were the biggest beneficiaries, driving significant outperformance by the Nasdaq. Defensive sectors lagged as utilities, staples, and healthcare stocks were used as a source of funds for portfolio re-risking.

Other economic news was mixed last week. The NFIB’s Small Business Optimism Index fell to 89.8, very close to the 9-year lows reached last summer. Labor markets continue to show signs of renewed strength as initial jobless claims fell to 205k, the lowest print since September. And finally, the University of Michigan’s Consumer Sentiment gauge rose for the second straight month in preliminary January data, with improvements in both the current conditions and expectations components. Near-term (1y) inflation expectations fell 40bp to +4.0%, while longer-term (5-10y) inflation expectations remain solidly anchored at +3.0%.

Albion’s “Four Pillars”

Economy & Earnings

US GDP rebounded to +2.6% in Q3 after falling in 1H22, and corporate operating margins remain solid at ~12% on the S&P 500. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.

Valuation

The S&P 500’s forward P/E of 17x is slightly above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.

Interest Rates

Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in two additional 25bp hikes in 2023, with a “terminal” Fed Funds rate slightly below 5% for this cycle.

Inflation

After reaching 40yr highs in spring of 2022, inflation has begun to moderate in recent months. Headline inflation eased over the summer on falling energy prices, and core inflation followed suit in Q4. Goods inflation has fallen due to softening demand and excess inventory, while heavily lagged housing data is one factor keeping reported services inflation elevated, at least for now.