The Fed Re-Focuses
After a difficult year characterized by higher interest rates, high inflation, and recession fears, markets rallied late in November on fresh Federal Reserve (Fed) governor commentary regarding their potential future moves, providing some semblance of relief for investors.
Jerome Powell, Federal Reserve Chair, took to the podium to address the Fed’s evolving plan of attack for bringing down inflation. Remarks indicated that we will likely see a smaller rate increase in December at 0.5%, versus the historic 0.75% of the previous four hikes this year. While this smaller rate hike is a positive sign, Powell assured that the Fed and monetary policy will remain restrictive until inflation is at a palatable level.
In fixed income, the yield curve remained inverted, meaning that long-term Treasuries rates are below short-term rates. The significance of a yield inversion is that it is a fairly reliable historic signal of a future recession.
In the meantime, investors are awaiting December’s inflation report, as well as the final Fed meeting of the year—during which the expected 0.5% rate hike may occur—as major remaining data points to close out this challenging year.
It’s evident that investors in both equity and fixed income markets have navigated a difficult backdrop this year, with the Fed having been center stage as they’ve battled inflation with historic rate hikes. While this approach was necessary in response to persistent inflation, the first - and major - concern remains that the tighter monetary policy will trigger a recession.
Strategic, active, and de-risking have been our three themes of the year as we’ve monitored these macroeconomic developments. This approach, paired with our outlook and our forecast for an economic slowdown, has us being proactive and calculated in our decision making. Looking ahead, our investment analysts are preparing their ‘shopping lists’ for when opportunities arise and for when we’re confident it’s the right time to begin buying.
Checking in on the Fed and Market Rally
Earlier in November, Chair Powell first shared indications that the pace of rate hikes may slow in coming months (a sentiment reiterated again at the most recent press conference), while setting the expectation that rates will remain higher for longer.
This sent markets lower and led to an aggressive re-pricing higher of the Fed’s terminal rate. This was promptly met with weaker than expected inflation numbers that sent financial markets significantly higher and yet again led to a re-pricing of the Fed’s terminal rate—this time much lower.
We believe that the Fed has become an inflation fighting institution, and we expect them to remain committed to that task. As they’ve indicated rates will remain higher-for-longer in combatting inflation,
which is understandable when inflation is running at levels roughly 4x the Fed’s target rate, as well as considering that underlying indicators continue to see pressure.
After breaking down this news, we share more views and our base case going forward in Checking in on the Fed and Market Rally.
- Economic Cycle
- The economy is moving late cycle with speed; a recession in the US is becoming increasingly likely; the Fed is on a warpath against inflation, as it has found itself badly behind the curve and is being forced by high and persistent inflation to tighten into an already weakening economy
- Stock Market
- US stock market volatility continues; market weakness has improved valuations, however, equities remain expensive by longer-term historical standards; valuations may be partly explained by robust corporate profitability, as EBIT margins have climbed to historical highs; rising input costs are posing a risk to the ability of corporations to maintain this elevated level of profitability; returns will be harder to come by and stock selection will be increasingly important
- Bond Market
- Interest rates have risen well off their lows reflecting shifting expectations on inflation, growth, and central bank policy; corporate and municipal bond credit spreads have widened, but not enough to make them materially more attractive at this time
- Important Issues on the Radar
- Ukraine-Russia War: an environment of elevated geopolitical risk entails a general risk-off environment, lending upward support to the dollar, gold, and commodity prices
- China’s Economy: debt and property markets, as well as their strict continued adherence to a zero-COVID policy, remain major economic issues with potential spillover effects on the entire global economy; trade tensions continue to impact global trade and supply chains
- Inflation: a confluence of massive policy stimulus, tight labor markets, gummed-up supply chains, and rising energy costs are causing inflationary forces to broaden and become more entrenched than previously expected; conflict in Ukraine and lockdowns in China have added to price pressure
Sources: Wall Street Journal
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