FED POLICY IN FOCUS
Markets rallied for the second consecutive month in November as investors became increasingly optimistic that the Federal Reserve would move to slow down their current pace of interest rate hikes in December. The chorus for a less aggressive Fed grew louder on November 30th when Fed Chairman Powell spoke at the Brookings Institute and stated, “the time for moderating the pace of rate increases may come as soon as the December meeting.”
Moderating the pace of future federal funds rate increases (from .75 basis points down to the expected .50 basis points hike) should not be perceived as a “pivot” by the Federal Reserve as monetary conditions will continue to tighten to reign in the current level of inflation. The Fed has raised the target range for the federal funds rate six consecutive times, pushing borrowing costs to their highest levels since 2008. Chairman Powell added that more rate hikes will be needed to tame inflation and that the ultimate terminal rate may be higher than the Fed had previously thought. This would warrant the Fed’s policy stance to remain restrictive for some time.
The Consumer Price Index (CPI) gained 7.7% year over year in October, down from the June peak of 9.1% but still well above the Fed’s long-term target of 2% inflation. The good news is the direction for inflation does appear to be trending lower.
INVERTED YIELD CURVE – RECESSION LOOMING?
An inverted yield curve typically occurs when long-term interest rates are lower than short-term interest rates. This typically signals that investors expect future economic growth to be weak, as they are willing to accept lower returns on long-term investments in exchange for the perceived safety of a shorter-term investment. An inverted yield curve is often seen as a predictor of a recession because it suggests that investors are concerned about the economy’s future health and are shifting their investments accordingly. Inverted yield curves have preceded many past recessions, though not all, so while it is not an unquestionable indicator of a recession, it is considered to be a reliable signal of economic weakness.
The Resilient Consumer – With that said, there has been much talk from market analysts that the economy will enter a recession next year due to persistently high inflation and tighter financial conditions resulting from the Federal Reserve’s policy rate hikes. However, despite these headwinds, personal consumption, which makes up 71% of GDP, has remained relatively resilient. In Q3, real personal consumption expenditure was up 2.1% from last year, which appears to be accelerating in Q4. We expect that consumption will continue to outperform consensus expectations next year, which is why a US recession in 2023 is not yet a foregone conclusion despite the probability of a recession increasing.
Supporting this narrative has been the resiliency of the labor market. Despite some recent announcements of job cuts, they have been concentrated in the technology sector. According to Goldman Sachs chief economist Jan Hatzius, “tech layoffs are not a sign of an impending recession.” Moreover, while the labor market has cooled, it is far from cold, as evidenced by the US economy adding 263,000 jobs in November, with the unemployment rate coming in at 3.7%, according to the Labor Department. Also recently reported were the JOLTS figures (Job Openings and Labor Turnover), still listing 10.3 million job openings, down slightly from the previous report.
Household balance sheets have also remained healthy, with excess savings accumulated during the pandemic through income transfers and consumption cutbacks. Households have been dipping into their savings to combat the impact of above-average inflation, but if inflation begins to recede, which we expect, consumer spending will continue into 2023, particularly in consumer services.
EARNINGS ESTIMATES
As the Fed has tightened monetary conditions, markets have experienced a contraction in valuations as evidenced by the decline in the price-to-earnings multiple of the S&P 500. The P/E ratio, or P/E multiple, is a financial measure used to evaluate the relative value of a company’s stock price or index (S&P 500), and it is calculated by dividing the price by the earnings. The historical P/E for the S&P 500 is approximately 16.5, as represented by the gold line in the chart to the right. As you can see during 2020, the P/E ratio reached 22.5 as multiples expanded due to massive amounts of government spending and historically low-interest rates.
The “price” or numerator of the equation has declined as interest rates have increased, but the concern going forward is what will happen to corporate “earnings” which is the other part of the equation. Corporate earnings forecasts are starting to be revised downward meaning the S&P 500 may not be as “fairly valued” as the chart would lead you to believe and it warrants greater attention heading into 2023.
Key Metrics to watch:
· Earnings Growth: For Q4 2022, the estimated earnings decline for the S&P 500 is -2.5%.
· Earnings Revisions: On September 30, the estimated earnings growth rate for Q4 2022 was 3.7%.
· Earnings Guidance: For Q4 2022, 63 S&P 500 companies have issued negative EPS guidance and 34 S&P 500 companies have issued positive EPS guidance.
HOME SALES SLOW
In October, existing home sales declined 5.9% to an annual rate of 4.430 million, narrowly beating the consensus estimate of 4.400 million. This marks the ninth consecutive month of decline, the longest streak of decline since records began in 1999. Sales were down 28.4% compared to the same time last year. The decline in sales was seen in all major regions and was due to a decrease in both single-family home and condo/co-op sales. The median price of an existing home fell to $379,100 in October (not seasonally adjusted) but was still up 6.6% compared to a year ago.
Falling affordability, mainly due to rising mortgage rates, has played a significant role in the recent downturn in sales. However, mortgage rates have recently fallen by about 50 basis points, which could help stabilize sales in the coming months. Despite the decline in sales, the inventory of existing homes on the market remains tight, with available listings down slightly from both September and a year ago. The months’ supply of homes rose slightly to 3.3 in October, remaining below the benchmark of 5.0 used by the National Association of Realtors to denote a tight market. Homes on the market are still selling quickly, with 64% selling in less than a month. While sales are under pressure, this is not a repeat of the 2007-09 housing crisis, as there is not a massive oversupply of homes, and the likelihood of a flood of foreclosures hitting the market is low. Many current homeowners have fixed long-term mortgages at low-interest rates, making them unlikely to default on their mortgages even if the economy weakens.
FINAL THOUGHTS
The saying “don’t fight the Fed” is relevant in today’s monetary environment. Chairman Powell, and the other Fed officials, understand that tightening monetary policy too far increases the possibility of a US recession. They also understand the threat of inflation and the importance of bringing it down to a sustainable level. Inflation is a lagging indicator, and interest rate hikes take months to work through an economy. We expect market volatility to persist in the near term regardless if the Fed is able to engineer a “soft landing” for the economy.