Stocks fell slightly yesterday in front of today’s conclusion of the Federal Reserve’s meeting where it is almost certain the FOMC will raise the Fed Funds rate by another 75-basis points to a range of 3.75-4.00%. But what investors really want to hear is the path for future rate increases.
The recent market rally finds its root in signs from leading Fed officials that the increase today may be the last 75-basis point rise. There is either a possibility or a probability, depending on who one listens to, of only a 50-basis point increase when the Fed meets again in mid-December. Investors will listen intently to Jerome Powell’s remarks this afternoon after the conclusion of today’s meeting for any hint of what the FOMC might do in December. Between now and then, there will be two employment reports and two CPI reports. Mixed in between will be other data showing the current pace of inflation deceleration. Those data points will decide the December action more than any comment Mr. Powell might make today. Indeed, I would expect him to emphasize that point and not get boxed in.
Nor should one expect the December rise, however steep it might be, to be the last. Most expect the Funds rate to reach 4.50-5.00% before the Fed completely pauses. Obviously, today’s expectation will be moderated by the path of inflation over the next several months.
In the interim, bond markets have paused after several months of rapid rate adjustments upward. The 10-year Treasury sits around 4% today having peaked to just over 4.25%. Rates at the very short end of the curve have continued to rise as they are tied closely to the Fed Funds rate, but from 2-10 years, there has been some moderation along the curve.
Moderating rates caused a positive reaction in equity markets so have third quarter earnings reports that modestly beat reduced expectations. One should note however, that earnings are backward looking. They reflect economic activity before the Fed got rates high enough to have a real tightening impact. The Fed Funds rate during the quarter averaged less than 3%. That is hardly tight when compared to inflation that was closer to 8%. That spread will reverse soon. When it does, we will see an economic impact.
While many reporters and pundits have long baked in a recession into their 2023 forecasts, it is still not a foregone conclusion. The job market is still too tight. Job openings actually grew once again in September. This Friday’s employment report is one of the key data items that will impact the Fed’s path going forward. Ideally, one would want to see employment growth falling toward or below 200,000 with some moderation in the rate of increased wages. At the moment, that’s a hope, not a prediction.
October was the best month for stocks since 1976. It came after one of the worst Septembers on record. Obviously, we appear to be at some transition point that has created both confusion and hope. Since World War II, the average decline before the onset of an actual recession has been a shade over 5%. This time, however, stocks declined 25% and no one is sure yet whether there will even be a recession. The reason for that disparity is the clarity of the Fed’s messaging. It started to lay out a road map of rate increases beginning late in 2021. Investors heeded the warning. Declines accelerated as the Fed ramped up its pace of rate increases in response to inflation that proved stronger and more persistent than previously thought.
Now both the Fed and the markets seem to be on the same page. Both believe inflation has peaked, but there isn’t a lot of agreement on the pace of decline nor is there consensus on the economic damage that will be inflicted courtesy of all the rate hikes.
Part of the inability to forecast can be attributed to the impact of the Covid-19 pandemic. Some companies and industries thrived during the pandemic, benefitting from a stay-at-home and work-at-home behavior. However, in 2021 and 2022, they paid the price. Demand pulled forward during the pandemic disappeared once everyone escaped. Conversely, businesses that virtually died when behavior was restricted thrived when the doors opened. Travel related companies are an obvious example. These shifts back and forth helped to create supply chain snarls and accelerated prices. Thus today, your plane ticket is more expensive while, at the same time, home prices are falling and apparel is on sale everywhere. Over the next year or so, the situation will normalize. That is as good a reason as any for the Fed to keep rates elevated but slow the pace of any future increases until it can sort out what parts of inflation are cyclical and what parts are systemic.
That brings this morning’s discussion back to markets. 30 days ago, all was doom and gloom. Often, when skepticism is that severe, stocks get cheap, but not all stocks were cheap. The biggest tech names not only showed signs of slowing growth, they showed increasing signs of maturity. Investors ran from those names. Since the top half dozen companies within the S&P 500 comprised close to 25% of the index’s value, there has been a rapid reallocation process. That process doesn’t appear complete but it explains a lot of the sudden buoyancy in stock prices away from the names at the top of the S&P 500.
It also means stocks, overall, are no longer cheap. Stocks today reflect an expectation of flat earnings next year. That’s possible. It also may be a bit optimistic. The likelihood that it understates tomorrow’s reality is small. Seasonally, November and December are strong months for stocks. But normally, one isn’t staring in the face of an economic slowdown at this time of the year. As mentioned earlier, the big decline in stocks has discounted a lot of bad news well telegraphed by the Fed. That suggests markets may have already set their lows for this cycle, but it doesn’t argue for a November that will match October’s rapid runup.
More than likely, volatility will continue. Maybe not at the pace of September and October, but still choppy until there are clearer signs that inflation is on the right trajectory down. The Fed’s job of raising rates will be done soon, but that is only half the job. The Fed ultimately has to reset rates at some level it feels is neutral, a rate that doesn’t retard or stimulate growth. My best guess is that the rate will be close to 3%, not far from where the Fed Funds rate is today.
That means that equity investors must adjust. No longer will borrowed money be “free”. Lenders will get a real return. The discount rate for future earnings will be higher than it has been for over a decade. That means the P/E for rapidly growing companies will moderate. Euphoric behavior will take a long time to return. Today’s returns (i.e., dividends) will carry more value. For decades, the S&P 500 was deemed overvalued when the dividend yield fell below 3%. It is below 2% today. Companies today are rewarding investors more via stock buybacks than they did in the past, but higher neutral rates will make dividends a more important component of total return.
One thing I say often is that investors buy stocks offensively and bonds defensively. Stocks go up because earnings go up. Growth will always matter. It will just be priced differently. Nonetheless, owning a stock of a company that can sustain above average growth and cash flow should be rewarding. That obviously points to technology, but growth happens all over. McDonalds and Procter & Gamble have grown for over 50 years. Well run businesses always gain share. Using the same two examples, there are plenty of places to get a hamburger or laundry detergent. McDonalds and P&G simply execute better persistently.
Hopefully, monthly changes in stock prices of over 10% are behind us, at least for a while. As the downward path of inflation becomes more apparent, market adjustments will moderate. The skies should clear as 2023 progresses. Equity prices a year from now should be higher. But, given current P/E and earnings expectations, they aren’t likely to be a lot higher. After most bear markets, the P/E ratio is very low reflecting washed out expectations. This time it is not, nor can one pencil in a rapid surge in future earnings. Any such surge would reignite inflation. Today, our economy is OK. Companies can manage around a flat environment. Stock prices already reflect that.
Today, David Schwimmer is 56. Ron Reed, a member of the 1980 World Series Phillies team, is 80. Tennis legend Ken Rosewall is 88.
James M. Meyer, CFA 610-260-2220