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Higher for Longer – Post Federal Reserve Meeting Commentary

Higher for Longer – Post Federal Reserve Meeting Commentary

Published on September 26th, 2022

Higher for Longer

The Federal Reserve concluded its meeting this past Wednesday by voting to raise its benchmark overnight interest rate by 0.75% to a new range of 3.00-3.25%. We believe an increase of this magnitude was widely anticipated by investors. The higher-than-expected August consumer price inflation data disclosed on September 131 supported the decision to maintain a rapid pace of increases, in our view. And financial press reports over the prior week that suggested an increase of this magnitude went unchallenged by Federal Reserve leadership.

The Federal Reserve also released its Summary of Economic Projections (SEP) in conjunction with Wednesday’s meeting. The SEP forecasts another 1.25% increase in the benchmark rate by year end.2 We believe this was modestly higher than expected by most investors. In our view, this creates a baseline expectation of another 0.75% increase on November 2, a further continuation of the current rapid pace. But a significant minority of the Federal Open Markets Committee provided a forecast consistent with a 0.50% increase on November 2,2so the debate remains unsettled, and will likely turn on economic reports, market moves, and geopolitical developments between now and then.

The Federal Reserve’s main message on Wednesday appeared to be that it would not deviate from what it outlined at its Jackson Hole conference. Federal Reserve Chairman Powell said on August 26 at Jackson Hole that the central bank’s commitment to taming inflation is “unconditional,” and that doing so would require maintaining a restrictive monetary policy “for some time.”3 In the September SEP, the Federal Reserve appears to have effectively marked to market its monetary policy under this rubric after inflation had proved more stubborn than expected over the last few months.2 Compared to a few months ago, the Fed now expects higher interest rates, slower growth, and higher unemployment.

In our view, the policy actions and related disclosures by the Federal Reserve on Wednesday modestly raise the probability of recession over the next 12 to 18 months. This may be reflected in the Treasury yield curve, as the 2-year yield fell further below the 10-year yield following the report. The spread between these yields widened to 0.53% from 0.41% the day before.4 The yield curve has been inverted by this measure since July 5. Inversions of this segment of the curve of this length and magnitude historically have been fairly good predictors of future recession. They are thought by some to suggest that monetary policy is too restrictive relative to the underlying strength of the economy.

Prior to the Jackson Hole conference, the U.S. equity market had been rallying. From the June 16 low of 3,666 the S&P 500 advanced 15% through August 25, the day before Federal Reserve Chair Powell spoke.5 Early on, we believe this rally was supported by the extremely oversold market conditions in mid-June. At the time, the Bull-Bear spread in the American Association of Individual Investors survey and the low percentage of NYSE-listed stocks trading above their 200 day moving averages were both indicating that the market was oversold.6 We have also heard from many trading desks around wall street that investor positioning is very light, meaning that there is much more cash on the sidelines than normal.  All of these speak to extremely bearish sentiment that tends to spark violent reversals on any positive news for the market. 

By August, we believed stocks were rallying based on the idea that inflation might have peaked and therefore the Federal Reserve would not have to raise interest rates as rapidly as feared.  On August 10 the July CPI was flat from June. Both headline and core measures were lower than expected. West Texas crude fell 29% from $122 on June 8 to $87 on August 16.7 At the time, the probability of a soft landing, where the Federal Reserve does not tighten so much as to induce a recession, seemed higher.

However, the market has now given back most of these gains. Investors reacted negatively to the Jackson Hole speech, the hot September CPI, and Wednesday’s Federal Reserve meeting. The S&P 500 declined 12% from August 25 to September 23 when it closed at 3,693.8 Overall, we think the Federal Reserve is tightening policy, and while recession risk in 2023 is elevated as a result, the bear market decline in the first half of the year priced this into the market to a significant degree. Excesses in things like cryptocurrency, unprofitable technology companies, SPACs and meme stocks have largely been wrung out of the market.  By August 12, the market had clawed back more than half its bear market losses from earlier in the year. That has happened 13 prior times since WWII and each time stocks did not exceed their prior lows.9

While we are now again close to that market level, in our view, it would take a severe deterioration of economic conditions from here for the S&P 500 to meaningfully decline below the June low.  Investors appear to have shifted into the “recession is coming” camp, and while we think that is a possibility, we also believe that if we do see a recession, it will probably be on the milder side.  Markets are likely to remain choppy as investors digest each data point on inflation and what it might mean for Federal Reserve policy as well as leading indicators and what they might mean for growth. 

Despite all of the above, we believe the risk/reward of the equity market is more balanced than may be appreciated.  We see many reasons for optimism. Europe has had more success placing natural gas in storage than feared, forestalling the worst-case scenario where there is widespread closures of manufacturing plants to allow citizens to heat their homes in winter. China could move away from its Zero Covid policy next year once Xi Jinping is established as Party Chairman in October and President in April. This could be supported by the rollout of an RNA vaccine following a recent change in Chinese regulation. U.S.-China tensions are de-escalating with an agreement to avoid U.S. delisting of Chinese stocks and a likely Xi-Biden Summit at the G-20 meeting on November 15 in Bali, Indonesia. Here at home, the labor market is healthy, corporate earnings are growing, credit spreads have not widened to recessionary levels, and the most recent manufacturing and services PMIs indicate reasonably healthy levels pointing to continued expansion.

To be sure, we also have many concerns. Atop our list may be the potential for escalation in the Ukraine conflict. Russia may act to curtail grain, fertilizer, or crude oil exports, which might exacerbate inflation and further increase the risk of global recession. But we do not believe Russia’s recent mobilization of reserve forces, or its nuclear rhetoric meaningfully changed this risk as it relates to the capital markets. In the U.S., some heavily indebted corporate debt issuers have recently faced challenges raising additional funds. And some emerging market nations are at risk of currency crisis or sovereign default. Most at risk are net importers of food and fuel, with trade deficits, and US$-denominated debt. But we believe they are of insufficient size and interconnectivity to spark a global conflagration.

Given our balanced outlook, we have taken some cautious steps in recent weeks to seek to add incremental upside capture so as to keep pace should the market advance from here. Because we expect volatility to persist, we are doing so opportunistically, and still maintain a higher-than-normal amount of spare cash. If economic data, geopolitical events, or market signals instead lead us to believe the risk-reward environment has deteriorated, we believe that we are already reasonably well positioned with shares of many companies we believe to be “recession resistant” as well as a portfolio exhibiting low downside capture, and we have the ability to get more defensive should we determine it might be necessary.

Source:

1 WSJ – Inflation Report Keeps Fed on Aggressive Rate-Rise Path 9/13/22

2https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20220921.htm

3https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm

4Bloomberg – US 2yr-10yr spread – daily closing prices

5Bloomberg – S&P 500 Total Return Jun 16 – Aug 25, 2022

6Bloomberg – AAII BullBear TD 2022

7Bloomberg – W Tx intermediate crude daily closing June – Aug 16, 2022

8Bloomberg – S&P 500 Total Return Aug 25 – Sept 22, 2022

9Bloomberg – Taking Stock: Indicator With 100! Track Record Says Bottom Is In, 8/16/2022

As of September 23, 2022

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