Capital Markets Outlook  |  Q1 2023

Slow your (pay)roll

Jason R. Vaillancourt, CFA, Global Macro Strategist

Slow your (pay)roll

Capital Markets Outlook offers perspective on the global economy and asset classes with insight on market history.

Jason Vaillancourt is a Global Macro Strategist on the Capital Market Strategies team. He provides in-depth global macroeconomic research to Putnam clients and the broader financial community.

Asset allocation for Q1 2023

We believe investment strategies that worked well in the second half of 2022 should continue to work in early 2023. The good news is that the end of the "free money" era means fundamentals matter again.

  • Maintain below-average overall risk in equity and high-yield asset classes and move credit portfolios to higher quality
  • Favor equities with better valuations (high free cash flow yield) and strong balance sheets
  • Have some exposure to commodities

Wage inflation continues to pressure the Fed in 2023

We believe markets expect inflation to decline sooner than it will, given January reports of growing payrolls and abundant job openings. Below, we explain why inflation is likely to keep the Federal Reserve in an aggressive stance and keep short-term interest rates high for much of 2023. This will in turn limit the upside for stocks.

Financial markets and the Fed disagree

As we focus our attention on 2023, many of us may need to readjust our mental frameworks. The wild pandemic-era swings in macroeconomic data may have conditioned everyone to expect full economic cycles to play out over a time frame measured in months. But a glance at the long-term chart of any macroeconomic datapoint would make it clear to even the casual observer that spring 2020 through winter 2021 was anything but normal.

Thankfully, in the realm of macro, at least, things finally seem to be approaching something close to normality. With that comes the expectation that time horizons should likewise also return to their previously scheduled program.

But for the wide disparity of expectations around the path for financial markets in 2023, there seems to be almost universal agreement that core inflation will decline meaningfully in a straight line over the next 18 months. That consensus forecast is at odds with the FOMC's thinking, setting up a very important showdown through the course of the new year.

Figure 1: Financial forecasters expect a steady decline in inflation

Change in Personal Consumption Expenditures (PCE) Price Index as forecasted by 45 economists surveyed by Bloomberg

Financial forecasters expect a steady decline in inflation chart

Sources: Putnam and Bloomberg.

The Fed keeps its word

As we have written before, investment outcomes are dictated by what the Fed will do as opposed to what it should do. A lot of ink has been spilled in the financial press focused on the latter. We prefer to focus on the former. The Powell Fed has been very transparent and continues to do exactly what it said it would do. We believe there is no reason to think that changes in 2023.

The drivers of inflation remain strong

In Fed Chair Jerome Powell's December 14 press conference, he described the path of the Fed's fight to restore price stability. This path has three distinct components:

  1. Repair of global supply chains, which should stem inflation in goods prices
  2. A recognized long lag between rents/house prices and the flow through to housing services prices
  3. Non-housing-related core services prices, driven primarily by tightness in the labor market

Figure 2: Wage pressures drive services inflation

Wages overall and services wages, 12/31/02–12/31/22

Wage pressures drive services inflation chart

Sources: Atlanta Federal Reserve, U.S. Bureau of Labor Statistics.

Critically, that last component represents 55% of core PCE. Even if inflation were 0% everywhere else, the inflation rate in non-housing-related services would need to drop to 3.6% for overall core inflation to return to 2%. With the former rate currently running at 7.3%, we clearly have a long way to go — hence the Fed's concern.

The futures market expects a cut too soon

In addition, a fair amount of research supports the idea that the U.S. economy is less sensitive to interest rates than it has been historically.1 This means a policy of higher for longer should be the base case, in stark contrast to a federal funds futures market pricing in a cut to the policy rate in mid-2023.

The labor market is still tight

A macroeconomic puzzle is making headlines as we turn the calendar on a new year. Recently, a large disparity emerged in job growth numbers implied by the household survey versus those implied by the establishment survey.2 This is noteworthy because the former would suggest that maybe we can worry less about a too-tight labor market.

It is certainly the case that these two measures can give a very different picture of the labor market at turning points in the cycle (and are subject to large revisions after the fact). However, we think it is premature to sound the all clear on the risk that flow-through from a tight labor market makes its way into service inflation. Despite the recent uptick in layoff announcements3 (which, like initial claims for unemployment insurance, tend to be seasonal), they are still below their pre-pandemic cycle average.

Wage pressures keep the Fed worried

Workers will be loath to relinquish the bargaining power they perceive to have gained over the past year. Consider these developments:

  • The 11th-hour deal the government imposed upon over 100,000 U.S. rail workers to avoid strikes includes a 24% pay increase over 5 years retroactive to 2020 and an $11,000 immediate payout
  • Delta recently agreed to a new contract with its pilots, delivering a 34% wage increase over 3 years that includes an immediate payout equivalent to 22% of its 2020–2022 earnings. This is likely to set the benchmark for other airlines
  • The 2023 National Defense Authorization Act includes a provision for a 4.6% pay raise for active-duty military employees,4 the largest in 20 years
  • The annual Social Security cost-of-living (COLA) adjustment will mean that recipients in 2023 will see the largest increase in their benefit checks since 1981

Ahead, the UAW's contract with the Big Three automakers, the Writers Guild union contract, and the contract between the Teamsters Union and UPS (covering 340,000 workers) will all be up for renewal in 2023. Consider also that the child day-care services workforce is down 8% from pre-pandemic levels, which will be an additional inhibitor to the labor force participation rate. Combine a strong labor market with a still substantial reserve of excess savings,5 and you have all the components in place to keep the Fed up at night.

Pressure keeps short-term rates higher

Of course, inflation is slowing. But we have long thought that the key problem for the Fed and other central banks is what happens if it does not slow enough to get back to their targets. It is certainly the case that recessions bring inflation down from high levels (see the slowdowns in ’73/’74 and ’80/’81 in Figure 3. We use the National Activity Indicator as the best single coincident descriptor, composed of 85 individual items across various parts of the economy). But developed market economies, particularly the U.S., continue to be stubbornly resilient, and therein lies the problem. A fiscal policy boost is also on the way, after President Biden at the end of December signed a $1.7T omnibus budget bill that includes an 8% increase in federal spending. We think it is likely that the widely anticipated slowdown will take longer to appear than most expect, and this will keep upward pressure on rates at the short end of the yield curve, which in turn will likely cap the upside for the equity market.

Figure 3: Economic activity remains positive after 9 months of aggressive policy

Chicago Fed National Activity Indicator, 12/31/1972–12/31/2022

Economic activity remains positive after 9 months of aggressive policy chart

Source: Chicago Federal Reserve.

Reduce risk and favor quality

The good news is that the end of the "free money" era means that fundamentals matter again. The things that worked in the second half of 2022 will likely continue working for a while longer. We continue to suggest that investors maintain lower-than-average overall risk levels (in assets such as equity and high-yield credit), have some exposure to commodities, shift credit portfolios up in credit quality, and favor equities with favorable valuation (think free cash flow yield) and strong balance sheets.

1 See the following for just one recent example: Sinha, Nitish, and Michael Smolyansky (2022). "How sensitive is the economy to large interest rate increases? Evidence from the taper tantrum," Finance and Economics Discussion Series 2022-085. Washington: Board of Governors of the Federal Reserve System,

2 For a detailed discussion of the methodologies, see "Comparing employment from the BLS household and payroll surveys" at the Bureau of Labor Statistics website,

3 "The Challenger Report. November 2022: Job Cuts Soar 127% As Tech Drains Jobs; Highest Monthly Total Since Jan. 2021."

4 If the military were a stand-alone employer, it would be the third-largest employer in the country, behind only Wal-Mart and Amazon.

5 At current run rates, the stock of excess savings could last beyond mid-2023. See Aladangady, Aditya, David Cho, Laura Feiveson, and Eugenio Pinto (2022). "Excess Savings during the Covid-19 Pandemic," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, October 21, 2022,

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