Why 2023 Is Off to a Good Start for the Markets

Key Takeaways

• It’s starting to look like the outlook for inflation is getting better, that we’ve definitely seen a peak in inflation. And then more importantly, we’re seeing signs that it’s beginning to trend lower.
• There were really two parts of the jobs report that people focused on. The first was job growth, which tells us the economy’s still doing well. The second was that wage growth data showed some easing of the upper pressure that we’d seen there.
• When we look more broadly across the stock market and what we’re expecting for earnings, we are expecting to see earnings decline for the fourth quarter for the first time since Q3 2020. That’s a reversal from just a few months ago when earnings were expected to be up for the fourth quarter.

Ivanna Hampton: Can investors breathe a bit easier in 2023 compared to 2022? Two closely watched reports dropped in the first couple of weeks of the year, and the markets are eyeing both as potential signs that the Fed could ease up on hiking interest rates. Morningstar, Inc.’s chief markets editor and Smart Investor newsletter editor Tom Lauricella is joining me to break down this week’s headlines. Hi, Tom.

Tom Lauricella: Hi, there.

Hampton: It’s been a busy week as January has kicked off. Describe what’s been driving the action.

Lauricella: Well, the main news so far since we kicked off 2023 has been economic news. These kinds of sort of macroeconomic reports really dominated the markets last year, especially with the focus on inflation and the Fed. And so right out of the gate, we had two key economic indicators that really have, I think, helped get us off to a little bit more of a steady, stable start, certainly compared to where we were at this time last year when everything was just beginning to roll over into what became a really brutal year for both bonds and stocks.

Hampton: Let’s first dig into the latest Consumer Price Index report. Inflation peaked at 9% last June, and it’s fallen for six straight months. It’s now sitting at 6.5%. What’s pushing inflation down?

Lauricella: Well, what we’re seeing here is a combination of things. First, some of the factors that had boosted inflation early in last year, such as the ripples from Russia’s attack on Ukraine, which drove up energy and commodity prices, that’s starting to roll off and fade. We’re also seeing some of the supply chain snarls that have driven a lot of price increases. Those have started to roll off. And then, of course, what we have is the beginning of the impact of the Fed’s interest-rate increases potentially beginning to have some bite. And so we’re finally starting to see some good news on inflation.

And most importantly it’s starting to look like the outlook for inflation is getting better, that we’ve definitely seen a peak in inflation. And then more importantly we’re seeing signs that it’s beginning to trend lower. The real question is how much lower will it go? And what we saw in the most recent report gave us some good indications that perhaps the Fed’s 2% target may actually be starting to come into focus here. Still have a ways to go, no question about it, but we’re headed in the right direction. At least that’s where we are right now.

Hampton: Before the CPI report, we had the December jobs data, and as your team reported, the December jobs report signaled strong growth, but at the same time, wage growth was easing. Why does that matter?

Lauricella: This was an important report. I mean, the jobs report is always important for the markets in terms of telling us what’s happening in the economy. There were really two parts of it that people focused on. The first was just simply job growth, which tells us the economy’s still doing well. I mean, we haven’t seen signs of things really tilting into a recession yet. Overall, job growth was pretty solid.

But when it comes back to that question of inflation, there was another important reading within the jobs report, and that is the data on wages. And what the wage growth data showed is some easing of the upper pressure that we’d seen there. The concern had been that if we had continued upward pressure on wages, that we would be entering into what they call a wage price cycle. Essentially just the more people get paid, I mean, it’s a good thing, but on the other hand, it also means that it helps fuel inflation. And that’s particularly the case in services sectors where there’s a very close connection between wages and how much companies charge. So, the fact that we saw some easing of wage pressures was taken as a very good sign for future inflation, which fed back into some of that decent feeling about the CPI report.

Hampton: Now looking ahead, it’s earnings season, with the big banks kicking things off. An article appeared in the Smart Investor newsletter, “Five Stocks To Watch For Q4 Earnings Identify Some Key Trends.” We’ve already seen some bank earnings. What’s the story there?

Lauricella: Yeah, so earnings kicked off here today as we record this video. We saw earnings from JPMorgan, Citi, Wells Fargo, some of the biggest banks in the world, really, and there were some good numbers. In particular, what we saw was that banks are benefiting from rising rates. That means that they’re able to earn more profits on their loans. So, we had strong net interest income from banks like JPM and Citi. There’s some caution ahead about a recession, as far as the impact on financials, but so far banks seem to be saying that they’ve got everything under control and they’re not really too worried about a significant downturn in the economy at this point.

Hampton: What are some of the other key stocks and trends to watch?

Lauricella: When we look more broadly across the stock market and what we’re expecting for earnings, first of all, overall we are expecting to see earnings decline for the fourth quarter for the first time since Q3 2020. That’s a reversal from just a few months ago when earnings were expected to be up for the fourth quarter. Why that matters is because stock prices have a strong relationship to earnings. And there’s a question for this year in terms of are earnings expectations too high? And if earnings decline more than expected, that could put some downward pressure on the stock market.

But within the market, there are some other sort of key sectors that we look at in this story. First of all, energy, which was the top-performing sector in 2022, on the back of those higher oil prices, we’ll be watching energy stocks across the board. Our analysts at Morningstar expect another strong year for earnings in energy, but not as strong.

Another sector to watch is the communications sector, which was the opposite of energy last year. Communications stocks were down 41% last year, the worst sector in the market. This includes names like Alphabet, Google’s parent, Facebook’s parent company Meta, and Disney. We’ll be watching Google in particular because they’re very much tied into the economy with their online advertising. So that’s an important stock to watch as we go through earnings.

And then lastly, airlines. It’s been a bad week or two in terms of public relations for airlines with Southwest’s problem and then this problem this past week in terms of flights being grounded. But generally, our analysts here at Morningstar think that airline stocks are undervalued and that the industry is continuing to bounce back from the pandemic. And so it’s going to be a sector to watch to see if airlines can outperform.

Hampton: Well, all right. So, another article appearing in the Smart Investor newsletter focuses on a recurring prediction that could have a chance of becoming reality: stock-pickers edging out index funds. Tom, you’re going to have to explain why that could be the case.

Lauricella: This is an interesting one. And it gets down to how we all put together our portfolios. Increasingly, over the last couple decades, folks have really leaned toward index funds; actively managed funds, just haven’t been able to keep up and beat the market. 2022 was a year where we saw actively managed funds doing a lot better. And, in fact, some of the biggest index funds, the kinds of funds that are in a lot of our 401(k)s and retirement plans, actually lagged the market last year. And that includes funds like S&P 500 index funds and the Vanguard Total Market Fund.

A lot of this has to do with how index funds are created. They’re weighted to the biggest stocks. And when you had a year like last year where Alphabet got crushed, where Tesla got crushed, all these big giant stocks took a big hit, bigger than the rest of the market, you actually saw a lot of index funds do relatively poorly. And this is a similar situation in the bond market as well. Similar reasons. These index funds, they’re not flexible. And when you do have a market like we had last year, the advantages that they’ve seen in many years turn to disadvantages. So, a very interesting story.

Hampton: Well, thank you, Tom, for giving us a preview of this week’s Smart Investor. I enjoyed our conversation this week.

Lauricella: Glad to be here.

Hampton: Well, be sure to subscribe to Smart Investor newsletter. You can catch up on the weekly rundown of Morningstar’s latest on the big market trends and investment opportunities. I’m Ivanna Hampton, a senior multimedia editor here at Morningstar.