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All Eyes on the Fed & Inflation Release

U.S. equities were lower this week, as the rally that began in mid-October stalled last week. The S&P 500 declined in six out of seven of the past sessions, as markets have grown more anxious over the growth prospects in the year ahead All 11 S&P 500 sectors lost ground, but the slimmest losses were registered by the counter-cyclical utilities (-0.3%), health care (-1.3%), and consumer staples (-1.8%) sectors. The sharpest losses were logged by the energy (-8.4%), communication services (-5.4%), and consumer discretionary (-4.5%) sectors. Treasuries ended the week mostly weaker, with the 10-year yield at one point falling to around 3.40% and ending the week near 3.60%. The dollar index ended the week higher.

The services sector remains strong, and we expect service sector growth to remain strong as consumers spend more on goods rather on services. November’s Institute for Supply Management (ISM) Services index unexpectedly rebounded to 56.5, reflecting resilient consumption and activity over the fourth quarter. The service ISM is above 50 and increasing, which implies the service economy, the largest part of the total economy, is expanding. Some good news is that the underlying components signaled some inflationary pressures are easing, as the prices paid index slightly declined and the supplier deliveries index declined. Consumer sentiment slightly improved but remains historically low. The preliminary Michigan Sentiment index rose higher than expected in December, to 59.1 from 56.8 Although sentiment increased this month, it did not increase by enough to offset the decline in November. The recent decline in gasoline prices helped bring down one-year inflation expectations to a 15-month low of 4.6%. We expect inflation expectations to lower in upcoming months as gasoline prices are trending lower.

Shares in Europe also fell on renewed fears of a recession as central banks tighten monetary policy to control inflation. In local currency terms, the pan-European STOXX Europe 600 Index ended the week 0.94% lower. Eurozone GDP revised higher, but recent PMI surveys point to recession. Eurozone retail sales in October posted their biggest monthly drop this year, while German industrial production weakened that month, less than expected. The central bank governor of Ireland, Gabriel Makhlouf, and the governor of the Bank of France, François Villeroy de Galhau, supported along with other European Central Bank (ECB) policymakers a half-percentage-point rate increase this month, which would take the deposit rate to 2%.

Chinese stock markets rose as China’s easing of coronavirus pandemic restrictions boosted investor sentiment despite a surge in infections in the coming months. The Shanghai Composite Index added 1.6% and the blue-chip CSI 300 Index gained 3.3% in its biggest weekly gain since early November, according to Bloomberg. In economic developments, China’s producer price index decreased in November and inflation fell to 1.6%.

All eyes are on the Federal Open Market Committee meeting next week, where we continue, along with most of the investment community, to expect the Fed will moderate the pace of interest rate hikes going forward, hiking by 50 basis points in December. According to the Fed Chairman Jerome Powell’s testimony “Interest rates need to remain higher for longer to lower inflation closer to the Fed’s 2% goal.” Going forward, the Fed will continue to be data dependent, focus on the cumulative effect and rate hikes, and will pay particular attention to November’s Consumer Price Index, which will be released next Tuesday.

The price of U.S. crude oil fell around 11% for the week to less than $72 per barrel. The decline pushed oil prices into negative territory on a year-to-date basis, as oil ended 2022 around $75. Last week’s closing price is down nearly 23% from a recent high in early November. The oil markets remained in focus amid the recent volatility in crude oil prices that came in the wake of this week's decision by OPEC and its allies, known as OPEC+, to hold its production plans steady, while the G-7 imposed a $60 per barrel price cap on Russian oil. Additionally, new sanctions by Europe went into effect on Monday that bans maritime services for the transportation of Russian oil.

Equity and bond market volatility will remain elevated until the “data-dependent” Fed becomes comfortable with inflation. We remain defensive in our positioning, and we’d look for opportunities to upgrade portfolios during market weakness, towards a possible S&P500 Index retreat towards 3.700 -3.750 area. Within equities, we continue to favor U.S. Large Cap exposure, since economic growth is rapidly slowing in Europe, which is close to a recession, and China’s strict COVID policies continue to weigh on manufacturing and growth. Within U.S. we favor segments exhibiting a defensive tilt toward low volatility, higher quality, and shareholder yield. We remain defensive in our credit positioning, with short to at benchmark duration and higher in credit quality. We expect credit spreads to leak wider to account for recession risks.

As we move into and through 2023, we think investor’s attention will shift, from falling inflation back to the health of the economy. We think this make investors to take a better look of cyclical versus defensive sectors, while the U.S. dollar will drift lower. In total, a disciplined portfolio diversification as well as opportunistic rebalancing will be beat toward 2023.

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