November Investment Comments
Despite the Federal Reserve enacting the most aggressive interest rate hikes since the 1980s, inflation continues to run near 40-year highs. In September, the Consumer Price Index (CPI) rose a greater-than-expected 8.2% from the prior year, and 0.4% from the prior month. The annual increase was down slightly from 8.3% in August and 9.1% in June, which marked the highest inflation in 40 years. The “core” measure of inflation, which excludes food and energy prices, rose 6.6%, accelerating from August and representing the largest increase since 1982. This was not welcome news, as the Fed had hoped more restrictive policy would have had a greater impact. Instead, inflation remains well north of the Fed’s 2% target.
The Fed’s preferred inflation measure, the personal consumption expenditures price index (PCE), is also running well ahead of its long-term target, rising 6.2% in August, which is the most recently available data. This is down slightly from July, but the core measure jumped to 4.9% from 4.7% the prior month.
Though it looks to be cooling somewhat, the labor market remains tight. The September jobs report showed employers adding 263,000 jobs, fewer than the 315,000 added in August and 537,000 in July. Despite slower growth, the unemployment rate returned to its pre-pandemic low of 3.5%, as the overall labor force shrank, and the participation rate remained below its pre-pandemic level. The relative lack of workers remains a key factor for the economy, and it is not easy to grow the workforce. There were 10.1 million job openings in the U.S. at the end of August, down from 11.2 million a month prior. Still, this represented 1.7 job openings per unemployed person.
Average hourly earnings in September rose 5% from the prior year, elevated but modestly below the pace in August and representing the slowest annual rate since last December. To put this in context, wages averaged 3.3% growth in 2019. The Fed is particularly concerned about tight labor markets that could result in persistent upward wage pressure feeding through to sustained high prices.
The strong labor market gives the Fed cover to continue tightening policy. In response to inflation that has consistently run ahead of its expectations, the Fed has increased the Federal Funds rate by 0.75% at each of its last three meetings, bringing its target range to 3.00%-3.25%. The upside surprise in the September CPI data resulted in the near certainty of another 0.75% increase at the Fed’s early November meeting and moved market expectations for a December increase from 0.50% to 0.75%. This would leave the target rate at 4.50%-4.75% at year-end from nearly 0% at the start of the year.
It is worth pointing out that market participants as well as the Fed itself have consistently underestimated the rate increases enacted during this hiking cycle. Exiting 2021, Fed projections reflected an expectation of a target rate for federal funds of just 0.75%-1.00% at the end of 2022. Persistent elevated inflation has driven a more rapid move than most envisioned. Where the Fed ultimately needs to take short term rates to achieve its inflation target remains unknown. According to the CME FedWatch site, rates are expected to increase to 4.75%-5.00% in early 2023, slightly ahead of the Fed’s own projections following its September meeting, with the most likely scenario that rates maintain that level for the remainder of the year. Given how far off prior estimates have been, it is hard to have too much conviction in that outlook but at least it offers a baseline market expectation. Meaningful deviations from this outlook are likely to move markets.
It is not necessarily the ultimate destination for rates that matters as much as the rate of change. Ideally, the Fed would have backed off its “transitory” stance on inflation sooner, allowing it to move slower to gauge the impact of its actions and more precisely calibrate along the way as it tightens policy. Unfortunately, that ship has sailed. Some have argued that the Fed will be forced to back off its increases sooner than expected because something “breaks.” We saw that in the UK as dislocations in the government debt markets required the Bank of England to step in to buy bonds to help protect pension funds that were forced to sell assets to cover collateral calls.
Others have questioned the Fed’s resolve when the economy slows, and unemployment picks up. Undoubtedly, there will be incremental political pressure to shift to a more accommodative stance as its policies have the intended effect of slowing the economy and raising unemployment. Policy makers have been careful to reiterate that the Fed will do what it takes to bring down inflation, with the risk of doing too little viewed as greater than doing too much. However, in a bit of mixed messaging, certain members have also gently hinted the Fed could, in some scenarios, back off sooner than expected. While any shift would far from signal a return to the highly accommodative environment from recent history, it would likely be a short-term positive for the market. Regardless, market-implied inflation expectations over the next five years are running about 2.4%, signaling belief the Fed will make meaningful progress in achieving its inflation goal.
Given the magnitude of rate increases this year, history would suggest recession over the next year or so is likely. How severe a recession remains the key question, though strong consumer balance sheets should help cushion the impact. It is worth noting typically in recessions equities bottom well before GDP does.
Looking across asset classes there haven’t been a whole lot of places to hide during the market’s downturn. The increase in interest rates has hurt both bonds and stocks, with a traditional 60/40 portfolio comprised of the S&P 500 and 10-year Treasuries down over 20% year to date. This would register as the second worst performance in history. Or look at bitcoin, down approximately 60% year to date, calling into question claims it is an inflation hedge.
The major stock indices are each in bear market territory driven by multiple contraction as earnings have remained resilient. The multiple the market is willing to pay for earnings is inversely correlated with interest rates. The yield on the 10-year Treasury is up to approximately 4.0% from 1.5% entering the year. Multiple contraction has driven market declines, as the forward P/E multiple for the S&P 500 has fallen from approximately 21.5x at the start of the year to closer to 15.5x. For context, this is below the 10-year average forward P/E of about 17.0x.
Meanwhile the overall earnings outlook remains relatively upbeat. For 2022 consensus estimates for the S&P 500 reflect 7% EPS growth with another 7%-8% earnings growth in 2023. Given what is likely to be a slowing economy combined with continued inflationary cost pressures, it seems more likely than not these estimates will need to be reduced. For individual companies, pricing power will be tested and those companies able to pass along the cost increases they are experiencing will fare far better than those that cannot. Owning growing, free cash flow generating companies with strong balance sheets and reasonable valuations is a sensible way to navigate this challenging environment.
James M. Skubik, CFA