Is The Fed Saga Nearing An End?
Is the Fed Saga Nearing An End?
A quick recap of our 10th Anniversary Celebration from last week including some fun highlights from the event itself.
Five Things You Should Know
- Equity Markets – were higher this week with U.S. stocks (S&P 500) up 3.93% while international stocks (EAFE) rose 3.24%.
- Fixed Income Markets – were higher with investment grade bonds (AGG) up 1.54% while high yield bonds (JNK) rose 3.00%.
- New PM – Following the resignation of Liz Truss last week the U.K. appointed former Chancellor Rishi Sunak as the new Prime Minister. Sunak’s initial priority circles around repairing the damage caused by Truss’ massive package of unfunded tax cuts. Many are hopeful that Sunak, who spent the bulk of his career in the private sector working for hedge funds, has the expertise to navigate a struggling economy and volatile markets.
- China Open to Cooperation – Amidst an uptick in new Covid cases/lockdowns and a stagnating economy, Chinese President Xi Jinping said that he is now willing to work with the U.S. to find common ground, both from a geopolitical and economic standpoint. This sets the stage for further conversation between the two nations at the upcoming G20 Summit in November.
- Key Insight – [VIDEO] A quick recap of our 10th Anniversary Celebration from last week including some fun highlights from the event itself. [ARTICLE] The S&P 500 has staged an impressive rally of over 10% since mid-October on hopes the Fed’s tightening cycle is nearing its end…are they right?
Insights for Investors
After a brutal September which saw the S&P 500 drop almost 10% that continued into the first two weeks of October, the pundits were out in force predicting more doom and gloom as the markets headed into earnings season. Outside of the former FAANG darlings, earnings have generally surprised to the upside and once again proven their resilience along with renewed hopes that the Fed’s tightening cycle may be nearing its end. The combination has sent equities higher with an approximate 10% gains across the major U.S. indices.
Are the markets “right”?
From a market technical perspective, there is a strong likelihood of retesting the 3800 level on the S&P 500, but if that holds, another piece of important evidence will be in place that a “floor” may be in.
Quantitatively speaking, the answer lies in inflation data and the Fed slowing its hikes, and this requires a bit more reading of the proverbial “tea leaves.”
As Tom Essaye pointed out, “Since last Friday, when the WSJ article suggested (editors note: they are a frequent source of Fed leaks) the Fed may hike 50 bps in December, markets have rallied on the idea that the worst of the global rate hikes are either 1) Already behind us or 2) About to be behind us, and the BOC’s (Bank of Canada) smaller than expected hike only furthered that sentiment. We should expect more of these “dovish hikes” in the coming weeks and months (but not from the Fed next week) as global central banks (minus Japan) seem to be in general lockstep on policy since the pandemic (they all cut rates to 0% and enacted massive QE, and now are all dramatically hiking rates).”
It is because of this coordinated, or coincidental, lockstep approach amongst central banks that markets paid special attention to recent comments from the Bank of Canada’s Macklem.
As Essaye continued, “Stocks melted higher as the BOC’s Macklem said that they were getting close to the end of the current tightening phase but “not quite there yet,” while also indicating the BOC expects a soft landing with global growth slowing from 3.2% this year to 1.6% in 2023 (notably not negative).”
The reason interest rates are so key to performance of the stock market was summed up well by Warren Buffett who stated, “The most important item over time in valuation is obviously interest rates. Any investment is worth all the cash you’re going to get out between now and judgment day discounted back. If interest rates are destined to be at very low levels … it makes any stream of earnings from investments worth more money.”
Evidence of the rate hike cycle ending sooner than was feared in September is growing here in the U.S. as well. We noted last week key Fed member Bullard’s comments to the effect that he expects the central bank to end its, ‘’front-loading” of aggressive interest-rate hikes by early next year and shift to keeping policy sufficiently restrictive with small adjustments as inflation cools. “You do have to think about what the reasonable level is.”
The biggest reason for this concern about “reasonable levels” and liquidity is not you or I, or the economy as a whole, but likely the Federal Government’s debt levels and corresponding debt service expense at higher rates.
As was summarized recently by Apollo who noted, “The level of government debt outstanding limits how much the Fed can raise rates. With total debt held by the public at $24.3trn, the 2% increase in the entire yield curve over the past six months will increase debt servicing costs by $486bn, see chart below. With net interest expenses expected on government debt in FY2023 at $442bn, the total annual debt servicing costs would rise to roughly $1trn. The bottom line for markets is that rising interest rates are becoming a significant drag on US GDP growth.” (See accompanying chart).
US Treasury Secretary Janet Yellen has addressed/expressed these concerns herself stating on October 12th that, “We are worried about a loss of adequate liquidity in the [Treasury] market" While Former US Treasury Secretary Larry Summers on October 21st, 2022, explained, “If your deficit projection starts to get out of control and your real interest rates start to rise rapidly, you can get into a kind of doom loop. We’re going to need to be watching our own fiscal projections in the United States very carefully.”
What does this all mean? As longtime Washington D.C. insider Harald Malmgren explained, “Look for Fed in coming months to suggest that the long standing 2% "normal" inflation target should be "realistically set in the 3% to 4% range.”
In short, the government’s debt levels and need to control costs are likely to lead the Fed to “shift the goalposts” on an acceptable inflation level to justify ending rate hikes sooner rather than later which would be bullish for stocks – especially at current valuations.
As we discussed last week, what lies ahead is most often more about people’s expectation of what lies ahead than the reality itself, so when expectations are bad enough, markets don’t need much to move higher.
Noted analyst from Fundstart Tom Lee summarized the current equity market set up this way: “Stocks have been "obliterated" and the recent stock gains look like more than a simple bear-market rally. For much of 2022 the consensus looked to be a drop in the S&P 500 to 3,200. But investor perception of risk is no longer one-sided, with inflation pressures easing and the Fed becoming more data dependent. The S&P "is down -20% in nominal terms, but down -28% on 'real terms' (CPI adjusted) … The Fed has won. Stocks have been obliterated. But this also means a 50% rally in equities would still leave stocks -15% on a 'real basis' - in other words, S&P 500 4,500 would still be consistent with Fed’s goals of tightening financial conditions."
And while sentiment/expectations have improved with bearish sentiment finally falling below 50 on the most recent AAII Investor Survey, it remains at 45.7% – well above its long-term average of just 30.5% indicating that markets still have room to climb the “wall of worry” to higher levels over the next year.
Have a wonderful weekend,
Tim and the team at TEN Capital
Data, Just the Data
Data points this week included:
- U.S. Jobless Claims – bumped up by 3K to a claimant count of 217K for the week ending October 20th. Initial claims of a loosening labor market have been put on pause as claims have fluctuated over the past month. The four-week moving average rose by 6.75K people to a count of 219k.
- U.S. PMI Composite Flash – fell from 49.5 to 47.3 in October and marks the second fastest rate of decline in the sector since 2009. Service output contracted the most in almost three years and manufacturing output rose fractionally. New orders and new business abroad fell, while input cost and prices remained historically elevated.
- U.S. Consumer Confidence – the Univ. of Michigan consumer sentiment survey rose from 58.6 to 59.9 in the month of October, marking the fourth consecutive expansion. The current conditions subindex bumped up to 65.6 and gauge for expectations went up to 56.2. Expected inflation in the survey rose to 5% and long run inflation sentiment was 2.9%.
- U.S. New Home Sales – contracted (10.9%) to a seasonal annual rate of 603K in the month of September, beating forecasts of a (24.7%) decline. Demand has fallen drastically with interest rates rising. The median sales price of new homes is $470.6K, up 13.9% from a year ago and the average sales price was $517.7K. Inventory is equivalent to 9.2 months.
- U.S. Durable Goods Orders – bumped up 0.4% MoM in the month of September after a 0.2% gain in August and beat forecasts of a 0.2% rise. New orders have risen for seven consecutive months. Excluding transportation and defense, orders fell (0.7%) MoM.
- U.S. GDP Adv. – the economy expanded 2.6% annually for Q3 according to the first advance reading, which outperformed forecasts of a 2.4% increase. The largest contribution came from a narrowing trade gap. Imports fell (6.9%) and exports rose 14.4%, thanks to energy products. Nonresidential investment rose 3.7%, while residential investment contracted (26.4%0 thanks to a slowing housing market.
- U.S. Personal Income & Outlays – rose by 0.4% MoM in September, which remains consistent with the last two months. A slight increase in compensation (private wages and salary up 0.6%) and income off receipts and assets led to the rise. PCE remained the same at a 0.3% rise MoM, as core PCE rose 0.5% MoM. Core PCE is a gauge the Fed watches closely when determining interest rate hikes.