Out of the woods?

Bottom Line

It has been a brutal three months for the financial markets. Since the Federal Reserve’s last quarter-point rate hike on July 26 that brought the fed funds rate to a 22-year-high target range of 5.25-5.50%, stocks and bonds have sold off sharply. The S&P 500 declined nearly 11% to October 27, the first time since January through March 2020 that stocks declined three months in a row. Benchmark 10-year Treasury yields soared from 3.75% to a 16-year high of 5% on Oct. 19. This marks the first time in history bonds have lost money three consecutive years. Finally, the volatility index (VIX) has nearly doubled, from 13 to 23 on Oct. 23.

Barbell-shaped year in 2023 Driven by the powerful performance of the Magnificent 7 technology stocks, the S&P enjoyed a 21% rally through the first seven months of 2023. Last month we thought stock valuations were getting ahead of themselves and expected the S&P to decline 8-12% during the historically choppy August-through-October period. October is typically the month that bear markets go to die. As if on cue, within the past fortnight, the index surged more than 6%, Treasury yields fell from 5% to 4.5% and the VIX plunged from 23 to 15. What sparked those rallies, in our view, is the growing perception the Fed has finished hiking interest rates. Policymakers unanimously voted last Wednesday to hold rates unchanged for the second consecutive meeting and third of the last four. Stocks historically rip on Fed pauses, and we expect the S&P to rally by about 12% from 4,100 to 4,600 over the next few months, completing our forecast for a barbell-shaped year.

Is the Fed done or not? While policymakers kept interest rates unchanged last week, Fed Chair Jerome Powell said they remain committed to achieving their 2% core inflation target, meaning they could hike at their meetings in December or January. But Treasury yields have soared around 125 basis points since the Fed’s last rate hike in July, and FOMC voters appear comfortable allowing the financial markets do their heavy lifting. We expect the Fed to remain on hold until the back half of 2024 before beginning to cut rates.

Inflation grinds lower While inflation peaked last year, headline measures are falling faster than core: 

• Nominal retail Consumer Price Index (CPI) spiked from 1.4% year-over-year (y/y) in January 2021 to a 41-year high of 9.1% in June 2022, but has since fallen to 3.7% in September 2023 (a 5.4% decline over 15 months). 
• Core CPI (which excludes food and energy prices) decreased from a 40-year high of 6.6% last September to 4.1% in September 2023 (a 2.5% decline over 12 months). 
• Nominal Personal Consumption Expenditures (PCE) index decreased from a 41-year peak of 7.0% last June y/y to 3.4% in September 2023 (a 3.6% decline over 15 months). 
• Core PCE (the Fed’s preferred measure of inflation) has fallen from a 39-year peak of 5.4% in February 2022 to 3.7% in September 2023 (a 1.7% decline over the last 19 months). The Fed projects it will reach its 2% target level by the end of 2026.

Wage inflation still too hot To reach that target, policymakers want wage growth to ease below 3% annually. But two recent data points suggest they will have to be vigilant: 

• Employment Cost Index rose a stronger-than-expected 1.1% on a quarter-over-quarter basis in the third quarter of 2023, up from 1.0% in the second quarter. That translates into an annualized gain of 4.3%.
• Average hourly earnings rose a stronger-than-expected 4.1% y/y in October, down from 4.3% in September.

Also critical are the significant wage gains airline pilots, UPS employees, United Auto Workers and other unions/labor groups have recently won. If companies pass along some of these increased labor costs to customers in the form of higher prices, inflation might be stoked, which could keep the Fed engaged longer than expected. 

Cumulative effect of Fed tightening Over the past 19 months, the Fed has shrunk its balance sheet from $9 trillion to $7.9 trillion while taking rates from near zero to a 5.25-5.50% range. But changing monetary policy is akin to turning a battleship in the ocean. It usually takes about 12-18 months for the full effect to filter through the economy. Third quarter GDP growth was a stronger-than-expected 4.9%, more than double the second quarter’s 2.1% increase. We believe that the cumulative effective of the Fed tightening will begin to impact the economy in the fourth quarter. We are forecasting 1.3% growth, while the Blue Chip consensus is at 0.7% and the Atlanta Fed’s GDPNow model is at 1.2%. 

ISM slowdown The economic deceleration manifested in last week’s weaker-than-expected ISM prints for October. The ISM manufacturing index at 46.7 (versus 49 in September) has been below the critical 50 contraction level for 12 months. The ISM services composite index at 51.8 (versus 53.6 in September) also arrived below expectations, and its business activity index at 54.1 was nearly 5 points below September’s level.

Yield curve inversions narrow Although the Fed is officially forecasting a soft landing, significant yield-curve inversions have historically been reliable indicators of a slowing economy, usually suggesting the bond market is concerned about the growing risk of recession. But these inversions have shrunk sharply in recent months:

• Fed funds/10s With the upper band of the fed funds rate at 5.5% and 10-year Treasury yields at 4.65%, the inversion is 85 basis points.
• Three month/10s With 3-month Treasury bills yielding 5.39% and 10s at 4.65%, this inversion is 74 basis points.
• 2s/10s With 2-year Treasury yields at 4.92% and 10s at 4.65%, this inversion is 27 basis points.

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