Globally, stocks edged lower with the MSCI All Country World Index sliding 1.9%. In the United States, returns were mixed with the Dow Jones climbing 1.2% while the S&P 500 fell 1.6%. The NASDAQ underperformed most indices with a 3.1% tumble. Equity markets overseas were mostly lower with European stocks slipping 0.5% while emerging market stocks dropped 3.8%. The 10-year U.S. Treasury yield rose 14 basis points to 4.02%.
Both the labor market and inflation appear to be too hot to handle for the Federal Reserve. Monetary policymakers now seem to believe that in order to tame inflation, labor markets must cool as well.
Interestingly, the dynamics to bring down core inflation are likely already in place with 30-year fixed mortgage rates now north of 7%. That should lead to lower home prices (and therefore lower shelter prices in the consumer price index) over the next two years. However, the Fed appears hesitant to acknowledge improving forward-looking inflation metrics. We suspect that the Fed fears doing so would test investor resolve.
History suggests that U.S. stock market returns may improve once the Fed raises rates for the last time. During the last six tightening cycles, the S&P 500 averaged a return of about 16% in the 12 months that followed the last rate hike.
Too Hot to Handle
Both the labor market and inflation data appear to be too hot to handle for the Federal Reserve with policymakers appearing to favor a weakening in the labor market in their pursuit of cooler inflation data. In theory, the Federal Reserve is trying to break the cycle of rising prices without breaking the economic cycle, but the risk of a U.S. recession is on the rise with inflation remaining well above the Fed’s 2% target and the labor market adding yet another 263,000 jobs in September.
In fact, the unemployment rate is now just 3.5% - the same as it was in January 2020 – pre-pandemic. Inflation, however, is much, much higher than pre-pandemic levels with the latest consumer prices index (or CPI) print coming down just a touch in September with an 8.2% headline print while core inflation headed higher – rising from 6.3% to 6.6% – as shelter prices continued to climb (see figure 1). Shelter prices are not the only component of core inflation rising, but they account for about 40% of the entire rise in core inflation over the past year.
However, there are plenty of signs that core inflation is set to fall in the year ahead. With 30-year fixed mortgage rates now north of 7%, home prices look set to cool materially over the next year or two as the debt service burden for new homebuyers has risen. As figures 2 and 3 show, mortgages rates lead national home prices by about a year, and national home prices lead shelter prices by about a year as well. This means that the dynamics to bring core inflation down over the next two years are likely already in place, but it will take time to play out. Though it should be noted that an extremely low U.S. home vacancy rate and a lack of oversupply could act to limit some of the downside to prices.
Interestingly, the Federal Reserve has yet to acknowledge this. It is hard to believe that they are not looking at the same forward-looking indicators that we are, but perhaps they are trying to be the “tough parent” to financial markets. Simply refusing to discuss improving inflation dynamics out of fear that investors would feel encouraged to test their resolve. In their view, financial conditions need to tighten further, and policymakers are willing to endure some economic pain (and criticism) along the way. In their view, this is the way.
The downside of this is unintended consequences. The recent turmoil in the UK serves as a good example. If the Fed was not tightening so rapidly while the Bank of England trails behind, the country’s currency likely would not have fallen to a 37-year low against the U.S. dollar over the last year. The U.S. is essentially exporting inflation to other countries with its rapid central bank tightening. That puts the pressure on the Bank of England to raise rates while the new UK government under Prime Minister Liz Truss tries to ease the impact of the energy crisis on consumers with unfunded tax credits. The result of these divergent policies was a surge in gilt yields and plunge in the currency. While markets have calmed down since then due to a U-turn from UK fiscal policymakers, the recent turmoil serves as a reminder that unexpected fires can pop up in unexpected places once the tightening flame has been lit (please see our CIO Strategy Bulletin | The Squeeze Is On for additional insights).
And yet, the Fed is likely to march on with another 75-basis point rate hike in November and possibly another 50-basis point rate hike in December. We still suspect that the Fed will decide to stop raising rates in the first quarter of 2023, but their language between now and then may not change much unless something breaks in financial markets.
What Does This Mean for Financial Markets?
It likely means that market volatility will not subside much until we get a sense that the Federal Reserve is a nearing a point of capitulation. History suggests that when that happens, U.S. stock market returns tend to average between 15%-16% over the following 12 months (see figure 4).
|Cycle Dates||Last Rate Hike||Fed Funds Rate||S&P 500 Performance|
|12-Months Later||24-Months Later|
|'83 - '84||8/9/1984||11.50%||13.8%||43.1%|
|'86 - '89||5/17/1989||9.81%||11.7%||17.3%|
|'94 - '95||2/1/1995||6.00%||35.7%||67.1%|
|'99 - '00||5/16/2000||6.50%||-12.3%||-25.1%|
|'04 - '06||6/29/2006||5.25%||18.1%||0.4%|
|'15 - '18||12/19/2018||2.50%||27.9%||48.0%|
If the Fed eventually does pause (or eventually pivot), it will most likely be because economic data have weakened (particularly the labor market). While we don’t have high conviction on this view, we wonder if investors could see a reversal of the first half of 2022 (where stocks rally as bond yields fall in 2023). Perhaps this is wishful thinking, but investors could likely use of dose of optimism right now.
What Should U.S. Investors Watch in the Week Ahead?
Public corporations will continue to publish their third quarter earnings reports with the consensus expecting S&P 500 earnings-per-share (EPS) to rise by 2.2%. We suspect that earnings may come in better-than-expected and that the primary takeaway will be that the U.S. economy is not yet in a recession. However, corporations may signal that they are still preparing for one.
The impact of the surging U.S. dollar on multinationals will also be interesting. Many corporations likely have currency hedges in place, but with U.S. exports becoming more expensive on the back of dollar strength, goods exporters may see their profit margins contract. This may be seen most acutely in the manufacturing sector.
In the week ahead, we will get earnings from Bank of America, Goldman Sachs, Verizon, Netflix, Tesla, and IBM. On the economic calendar, we will receive U.S. industrial production, housing starts, and existing home sales.
|Index||Weekly Chgchange in percent||YTDyear to date change in percent||12 Months12 month change in percent||Div. Yielddivision yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||13.7 bps||250.8 bps||250 bps||4.02%|
|Index||Weekly Chgchange in percent||YTDyear to date in percent||12 Months12 month change in percent||Div. Yielddivision yield in percent|
The Week Ahead
|10/18||10:00||Industrial Production MoMMonth over Month||SepSeptember||0.1%||-0.2%|
|10/18||10:00||NAHBnational association of home builders Housing Market Index||OctOctober||43.0||46.0|
|10/19||8:30||Building Permits||SepSeptember||1530k thousand||1517k thousand|
|10/19||8:30||Housing Starts||SepSeptember||1464k thousand||1575k thousand|
|10/20||10:00||Existing Home Sales||SepSeptember||4.69m million||4.80m million|