Dec. 19, 2022: Another Fed wakeup call. Another ‘meh’ response.

The biggest macroeconomic drivers for 2022 are now past with the U.S. Federal Reserve (Fed), European Central Bank, and the Bank of England all downshifting from 75- to 50-basis point (bp) moves in their benchmark interest rates, but without, in the Fed’s case, backing away from a higher-for-longer stance.

For most of the year, the major central banks have been unified around guarding against the risks of inflation becoming entrenched and have hiked rates into restrictive territory. But as the risks of overtightening become material, we’re now starting to see dispersion in the path forward between regions, reflecting very different underlying economies and drivers of inflation, said Matt Orton, CFA, Chief Market Strategist at Raymond James Investment Management. The Fed landed between the other two central banks with the Federal Open Market Committee (FOMC) broadly seeing terminal rate expectations higher and Fed Chairman Jerome Powell making a point to highlight that 17 of the 19 dots in the FOMC “dot plot” put the terminal federal funds rate at 5% or above. Orton has said for a while that it wouldn’t be surprising to see the terminal rate get to 5.25%, and he noted that Powell has been remarkably consistent in saying that rates need to be higher for longer.

“I expected that the European Central Bank and Fed meetings would serve as yet another wakeup call to investors who have been too optimistic in pricing a full central bank pivot,” Orton said, “but I still don’t think that everyone has received the message.”

To the contrary, Orton said it was quite remarkable how little rate pricing shifted after the Fed’s announcement: looking at prices for futures contracts before and after the FOMC decision, he said one likely wouldn’t know that there was a policy announcement in between, particularly one with a fresh set of hawkish projections.

“Clearly the market is rejecting the Fed’s forward guidance and is convinced that economic growth is slowing considerably and that the Fed isn’t going to finish the hiking process,” he said. The deeply inverted yield curve is perhaps the most pronounced example of this and there is scope for this inversion to continue. Having a 10-year Treasury note yield below 3.5% makes sense considering that the Fed’s gross domestic product (GDP) forecast at the December meeting was quite negative, worse than many prior recessions, but Orton said the front-end looks mispriced given a larger than expected terminal median dot (5.25% for the upper-bound) and only 100 bps of cuts projected for 2024 (versus the 135 bps of cuts that have been priced in overnight index swaps). “What’s clear to me, he said, “is that the clash between the peak inflation narrative and slowing economic growth will continue to play out well into 2023.”

“We’re really at this point where the market narrative is splitting in two,” Orton said. “The narrative has been dominated by inflation up to this point, and now economic realities are starting to set in. That’s where this tug of war is happening.”

Clearly, the market thinks the Fed cycle is over. I wouldn’t be so sure.

Risk assets haven’t been very constructive lately, though Orton said the weakness on Thursday and Friday shouldn’t at all be surprising. Thursday was particularly weak: The S&P 500 Index had its largest down move since early November (-2.5%), with 94% of stocks down on the day. Given that central banks were more hawkish than many of the “peak inflation” narrative bulls may have expected, he said some of the price action was probably taking chips off the table. But poor economic data that included China activity gauges, U.S. retail sales, the Empire State Manufacturing Survey, and the Federal Reserve Bank of Philadelphia’s Manufacturing Business Outlook Survey added to a bearish tone and highlighted that the journey to continue cutting headline inflation isn’t free. There is still quite a bit of work to be done to get inflation back to target, and Orton believes that the specter of rising rates will continue to constrain valuations. He said he expects markets to remain range-bound until investors accept a higher terminal rate and we have a sense of how long rates will remain in restrictive territory.

Consequently, Orton said he continues to focus on remaining defensive in the near term. Not much worked over the past week, but dividend growth and growth at a reasonable price (GARP) once again provided some insulation relative to the broader market and remain his favored positioning by leaning into quality, earnings stability, and profitability. The recent price action has the S&P 500 sitting just below its 50-day moving average (DMA) and any additional downside risks a further correction, he said. Negative momentum certainly has the upper hand and the breakdown in financials — regional banks in particular — is worth following given that the sector tends to reflect the general investor outlook on the economy. But as we look further into 2023, there are plenty of reasons to be more constructive. On the equity side, Orton noted that it’s incredibly rare to have two negative years in a row, especially after the scale of losses in 2022 for the S&P 500. There are also dislocations in the pricing of smaller companies, which right now are signaling a severe recession on the scale of 2008. Within fixed income, 10-year Treasuries are having one of their worst years in modern financial market history, municipals offer significant value, and for the first time in well over a decade investors can build a balanced portfolio without needing to extend out on the financial risk spectrum.

The clash between the peak inflation narrative and slowing economic growth will continue to play out well into 2023.

“There certainly can be — and likely will be — further volatility and pain, but the risk/reward looks much better heading into 2023 than it did heading into this year,” he said.

The U.S. 2/10 Curve remains incredibly inverted and oversold, Orton said. Whenever we’ve reached such levels in the past, there has been a steepening of the yield curve. However, he said he is not sure the reasons for steepening are good or a proper reflection of where we are right now. The yield curve typically steepens because the back end goes up and the front doesn’t. That’s not happening. A second reason is that the short-end declines in yield, usually a signal that the Fed cycle is over and not usually positive from a risk-asset perspective. “Clearly, the market thinks the Fed cycle is over,” Orton said. “I wouldn’t be so sure.”

It’s interesting to see that U.S. equities continue to lose ground relative to the rest of the world. Part of the initial push higher for global stocks was the massive rally in China on the reversal of its zero-COVID policy, but European equities also have been outperforming, though Orton noted that they’re coming up against some serious resistance and economic realities. He said he believes that select emerging markets look particularly interesting in 2023, but index exposure just won’t work. The same goes for the MSCI EAFE® (Net) Index. While Orton said he is fairly negative on the outlook for European equities, Japan looks much more interesting as the Bank of Japan embraces inflation and pursues policies that are starkly different from most other global central banks.

What to watch

In what is expected to be an otherwise quiet week, earnings from several big consumer-facing companies will be important to follow along with a slew of housing data reports, including existing home sales and housing starts, and the December homebuilder survey. Orton said the data will likely show housing coming down more quickly than is captured in the inflation reports, perhaps giving fuel for investors betting on that Fed pivot.

This week's data releases

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Basis points (bps) are measurements used in discussions of interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.

The federal funds rate, known as the fed funds rate, is the target interest rate set by the Federal Open Market Committee of the Federal Reserve. The target is the Fed’s suggested rate for commercial banks to borrow and lend their excess reserves to each other overnight.

The terminal rate is the rate at which the U.S. Federal Reserve stops raising the federal funds rate in an attempt to bring down inflation.

The U.S. Federal Reserve dot plot is a chart summarizing the Federal Open Market Committee’s (FOMC) outlook for the federal funds rate. Each dot represents the interest rate forecasted by one of the 12 members of the committee.

A futures contract is a legal agreement to buy or sell an asset at a predetermined price at a specified time in the future, which is known as the expiration date. Futures contracts are financial derivatives that allow investors to speculate on the direction of a particular asset and are often used to hedge the price movement of the underlying asset to help prevent losses from undesired price changes.

Hawkish, dovish, and centrist are terms used to describe the monetary policy preferences of central bankers and others. Hawks prioritize controlling inflation and may favor raising interest rates to reduce it or keep it in check. Doves tend to support maintaining lower interest rates, often in support of stimulating job growth and the economy more generally. Centrists tend to occupy the middle of the continuum between tight (hawkish) and loose (dovish) monetary policy.

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. Investors and market analysts watch certain yield curves for signs of inversion, when yields for longer-term debt instruments fall below yields on short-term debt with the same credit quality. Inversions are watched as potential signs of a weakening economy and in certain cases, a harbinger of recessions.

An overnight index swap is a hedging contract in which a party exchanges a specific cash flow with a counter-party on a specified date and uses an overnight rate index such as the federal funds rate as the agreed-upon exchange for one side of the swap.

The Empire State Manufacturing Survey is a monthly survey of manufacturers in New York State conducted by the Federal Reserve Bank of New York.

The Federal Reserve Bank of Philadelphia’s Manufacturing Business Outlook Survey is a monthly survey in which manufacturers in the Third Federal Reserve District, which includes Pennsylvania, New Jersey, and Delaware, indicate the direction of change in overall business activity and in various measures of activity at their plants: employment, working hours, new and unfilled orders, shipments, inventories, delivery times, prices paid, and prices received.

Headline readings of inflation, also known as nominal inflation, include food and energy prices, which tend to be more volatile than other components of the Consumer Price Index. By contrast, core measures of inflation exclude food and energy prices and are used as economists and other market participants as a more reliable measure of inflation trends.

Defensive stocks provide consistent dividends and stable earnings regardless whether the overall stock market is rising or falling. Companies with shares considered to be defensive tend to have a constant demand for their products or services and thus their operations are more stable during different phases of the business cycle.

Growth at a reasonable price (GARP) is a stock investment strategy that seeks to combine tenets of both growth and value investing in the evaluation and selection of individual stocks. GARP investors look for companies with consistent earnings growth above broad market levels but try to avoid companies with very high valuations. By trying to avoid the extremes of either growth or value investing, GARP investors often end up focusing on growth-oriented stocks with relatively low price-to-earnings multiples in normal market conditions.

A daily moving average (DMA) is a calculation that takes the arithmetic mean of a given set of prices over the specific number of days in the past; for example, over the previous 15, 30, 100, or 200 days.

The U.S. 2/10 Curve measures the difference between the rates of the 10-year U.S. Treasury bond and the 2-year Treasury note. Measured in basis points, it is watched as an indicator of where the U.S. economy is in the business cycle, as it the spread typically narrows as the economy moves through the cycle, reaches a low point and may go negative near the onset of a recession, then widens again during and after a recession.

Oversold is a term used to describe a security believed to be trading at a level below its intrinsic or fair value. The National Association of Home Builders (NAHB)/Wells Fargo Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse of the single-family housing market. The survey asks respondents to rate market conditions for the sale of new homes at the present time and in the next six months as well as the traffic of prospective buyers of new homes.

The ifo Institute Business Climate Index for Germany is based on a monthly survey of about 9,000 firms in manufacturing, the services sector, and construction, plus wholesale and retail sales about their characterization of their current business and their expectations for the next six months. It is published by the ifo Institute for Economic Research, based in Munich.

The Eurozone Consumer Confidence Indicator is conducted by the Directorate General for Economic and Financial Affairs to measure consumer confidence within different sectors of the economies in the European Union and in the applicant countries.

The U.S. Consumer Confidence Survey^®, published monthly by The Conference Board, reflects prevailing business conditions and likely developments for coming months based on consumer attitudes, buying intentions, vacation plans, and expectations for inflation, stock prices, and interest rates.

The Canada Consumer Price Index (CPI), released by Statistics Canada, represents changes in prices as experienced by Canadian consumers. It measures price change by comparing, through time, the cost of a fixed basket of goods and services that are divided into eight major components: Food; Shelter; Household operations, furnishings and equipment; Clothing and footwear; Transportation; Health and personal care; Recreation, education and reading; and Alcoholic beverages, tobacco products and recreational cannabis. CPI data are published at various levels of geography including Canada; the 10 provinces; Whitehorse, Yellowknife, and Iqaluit; and select cities.

The South Korea Producer Price Index, released monthly by the Bank of Korea, measures changes in the price of goods and services produced and transacted in the domestic market. The index is used to measure business trend indicators, deflators, and other economic developments.

The University of Michigan Index of Consumer Sentiment is based on monthly telephone surveys in which at least 500 consumers in the continental United States are asked 50 questions about what they think now and what their expectations are for their personal finances, business conditions, and buying conditions. Their responses are used to calculate monthly measures of consumer sentiment that can be compared to a base value of 100 set in 1966.

The Japan Consumer Price Index, released monthly by the Statistics Bureau of Japan, tracks core inflation by monitoring price changes in a wide variety of goods and services, excluding fresh foods but including energy, purchased by households nationwide.

The S&P 500 Index measures change in stock market conditions based on the average performance of 500 widely held common stocks. It is a market-weighted index calculated on a total return basis with dividend reinvested. The S&P 500 represents approximately 75% of the investable U.S. equity market.

The MSCI EAFE^® (Net) Index measures the performance of performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada. The MSCI EAFE^® (Net) Index subtracts any foreign taxes applicable to US citizens but not applicable to citizens in the overseas country.

RJIM22-0174 Exp. 4/19/2023