Stocks kicked off the first week of 2023 in positive territory while U.S. Treasury yields and the dollar fell after December's well-received employment report showed continued strength in hiring combined with slowing wage growth. The report ignited a sharp market rally on Friday as market participants viewed the data as a positive indication in the Federal Reserve’s battle against inflation that could ease pressure for further rate hikes and bring the central bank closer to hitting the pause button. Following Friday’s rally, the S&P 500 & Dow Jones posted weekly gains of 1.5% each, while the Nasdaq Composite climbed 1.0%. Volatility is likely to remain a big theme for equity markets this year as economic uncertainty lingers, and each data point becomes an opportunity for, hopefully, a clearer picture of the future.

While the December jobs report showed progress in the moderating pace of wage growth that may take some heat off the Fed, the cooling wage pressures stand in contrast to the continued strength of hiring that is keeping the labor market too tight for comfort for the central bank. The U.S. economy added 223k nonfarm payrolls in December (against expectations for 200k), and the unemployment rate fell from 3.7% to a 53-year low of 3.469%, despite tightening financial conditions. Meanwhile, average hourly earnings growth fell from 4.8% in November to 4.6% in December. This report was received by markets as a goldilocks scenario where the U.S. economic strength remains robust and resilient while inflation pressures gradually subside. However, the report also indicates limited progress on relieving the labor market strain that could keep the Fed on the offensive near-term to prevent elevated wage pressures from becoming entrenched.

Outside of the labor market, other economic data are pointing towards further deceleration in economic activity, including a surprising decline in the service sector in December, according to the Institute for Supply Management. The Services Purchasing Managers’ Index (PMI) fell into contractionary territory for the first time since the spring of 2020 as the index dropped from 56.5 to 49.6 in December, compared to expectations for a 55.0 reading (a reading above 50 is considered expansionary and below 50 indicates contraction). The service sector has been a strong point for the economy over the last few quarters as consumer spending has shifted from goods toward travel, leisure, hospitality, and other services. Unexpected weakness in this area is worth monitoring in coming months.

The week ahead will be a busy one with inflation in the spotlight on Thursday with the release of the December CPI report and the kick-off of fourth quarter corporate earnings season later in the week. The consumer price index reading for December is expected to drop to +6.7% from +7.1% in November and be up 0.1% on a month-over-month basis. Bank of America expects both core goods and energy prices to have declined again in December, but food inflation and core services inflation to have remained higher. The focus will be if the CPI update alters the view that the Federal Reserve will raise interest rates by 25 points in February and another 25 points in March and possibly one more hike in May before going on hold at a rate of around 5.0%. The corporate calendar will have its first full week of the year with the JPMorgan Healthcare Conference in San Francisco expected to see a plethora of earnings pre-announcements and guidance updates. The earnings season officially starts this Friday with banks and financial institutions stepping into the earnings spotlight.