The Fed and jobs give way to midterm elections and inflation
ANTHONY SAGLIMBENE – CHIEF MARKET STRATEGIST, AMERIPRISE FINANCIAL
WEEKLY MARKET PERSPECTIVES — November 07, 2022
Last week, the S&P 500 Index and NASDAQ Composite dropped for the second-consecutive week, falling 3.4% and 5.7%, respectively. The Dow Jones Industrials Average also moved lower on the week, declining by 1.4%. U.S. Treasury prices weakened across the curve. The 2-year Treasury yield closed higher by roughly 40 basis points on the week to finish at 4.69%, while the 10-year yield climbed approximately 20 basis points, closing at 4.17%. West Texas Intermediate crude ended the week up +5.4%, the U.S. dollar was a bit stronger versus the British pound (despite the Bank of England raising interest rates), and Gold ended last Friday at $1,638.80 per ounce.
Data continued to point to slowing manufacturing and services activity around the globe, particularly in Europe, where the October Eurozone services Purchasing Managers’ Index (PMI) dropped by its sharpest rate in nearly two years. And in Asia, the Hang Seng Index rallied roughly +9.0% last week (the biggest weekly gain in eleven years) on hopes of a zero-COVID policy pivot in China that could see the country more fully reopen. And below the surface last week, bearish sentiment among investors remained elevated amid cash levels rising at the fastest pace since the onset of the pandemic in 2020.
Companies point to a high degree of uncertainty in earnings calls; The Fed announces its fourth jumbo rate hike of the year
With 85% of S&P 500 Q3’22 earnings reports complete, the blended earnings per share (EPS) growth rate stands at +2.2% year-over-year on sales growth of +10.5%. A wide range of companies continue to point to a cautious outlook and a high degree of macro uncertainty. In aggregate, S&P 500 companies have pointed to ongoing inflation pressures and supply chain constraints, though issues on the supply side appear to be improving. A shift to goods for services remains a big theme across earnings calls, with a weaker housing market adding to lower spend on big-ticket items. In addition, margin pressures are a growing threat, with elevated inventories and some price cutting squeezing profits. We expect these themes to continue in the fourth quarter.
Last week, the Federal Open Market Committee (FOMC) raised its fed funds target rate by 75 basis points, the fourth such jumbo rate hike in as many meetings and as expected. The rate increase now brings the fed funds target rate to 3.75% - 4.00% — a level last seen when the target rate was falling in 2008 amid the Financial Crisis. As a result of last week’s rate hike, variable-rate debt and new mortgages will become more expensive. But the yields earned on savings accounts, CDs, and money markets are likely to rise with time, though at a slower pace.
Notably, Mr. Powell and company chose to keep inflation front and center in their messaging, and as we expected, somewhat disappointed investors who assumed the Federal Reserve would more broadly communicate a less aggressive stance. With that said, the Fed’s overall message last week was nuanced and did open the door slightly to a slower pace of rate hikes should data warrant such action. Yet, at the same time, higher rates are likely to linger for longer, further restricting economic growth and keeping stock volatility elevated.
The Fed is also likely to keep raising interest rates into the early part of next year in its fight to bring inflation down, regardless of the size of each rate hike. And if it overtightens and causes the economy to contract more than expected, Fed Chair Powell said the committee could reverse course (likely bringing rates back down quickly) to help support and restore growth. Bottom line: The Fed is not concerned about overtightening and would prefer to cause a recession instead of easing too quickly and seeing high inflation become entrenched in consumer and business behaviors.
The Fed remains focused on combating inflation; job growth slows moderately
But in a slight nod to the hope rate increases can slow at some point (maybe even in December), the policy statement added language stating that future rate increases would consider the cumulative tightening of monetary policy. This suggests the Fed is aware and now willing to communicate more broadly that rate hikes operate with a lag in the economy. New policy statement language helps reinforce the idea that there will be an eventual end to the rate hikes at some point. Net-net, the Fed raised rates as expected last week and maintained maximum flexibility on their forward policy as we suspected they would. In our view, the Fed will likely keep pressing rates higher as long as inflation is elevated and do so in an effort to cool labor trends and overall demand in the economy. Simply, investors should expect stock volatility to remain elevated as long as the terminal rate (possibly above 5% based on Mr. Powell’s messaging last week) remains a moving target.
Regarding labor trends, October nonfarm payrolls rose by +261,000 (the slowest monthly job gain since December 2020), while the unemployment rate rose to 3.7%. Job growth came in stronger than expected last month, though job increases were accompanied by an unemployment rate that rose from 3.5% in September. Notably, the second consecutive monthly decline in the labor-force participation rate to 62.2% (currently 1.2% below the February 2020 level and before the pandemic) suggests the rise in unemployment last month had more to do with people losing their jobs than workers either in or entering the workforce. Note: In August, when the unemployment rate last stood at 3.7%, the labor force participation rate was rising, suggesting more workers entering the workforce was the reason behind the rise in unemployment. Importantly, average hourly earnings decreased to +4.7% year-over-year in October from the +5.0% pace in September. However, wages rose +0.4% month-over-month and faster than the +0.3% clip in September, indicating wage pressures remain elevated.
Bottom line: The October employment report left mixed messages, leaving the Fed and investors wondering how to sort through the data until next month’s report. Combined with the September Job Openings and Labor Turnover Survey (JOLTS), which showed job openings increasing by +477,000 jobs, nearly 1 million more than expected, only complicates the equation. For example, job growth continues to slow but remains incredibly resilient, keeping the Fed’s well-entrenched narrative of raising interest rates higher and leaving rates higher for longer in place. And given labor trends are a lagging indicator, investors will need to anticipate how much damage to growth ultimately occurs from a higher terminal rate and before labor conditions slow enough to give the Fed pause. This is the market's conundrum regarding jobs at the moment — reinforcing the idea that a labor market that is too resilient could eventually lead to a more disruptive decline down the road should the Fed overtighten monetary policy.
Consensus calls for divided government following the midterm elections; investors also watching CPI data and earnings reports this week
Looking ahead to this week, the U.S. mid-term election, consumer price inflation, and the wind down to the third quarter earnings season will be in focus. Fortunately, the consensus view is for an election result that divides Congress over the next two years. In our opinion, such a result would likely be welcomed by investors that have dealt with an exceptional level of volatility and uncertainty this year as stock and bond prices have fallen. Combined with better seasonality factors, a divided government could play a role in helping improve very weak investor sentiment. In our view, market risks from the midterm election fall under outcomes that do not result in a divided government.
The October headline Consumer Price Index is expected to fall to +8.0% year-over-year from +8.2% in September. However, on a month-over-month basis, October headline CPI is expected to rise to +0.7% from +0.4% in the prior reading. Despite the influence of higher gasoline prices last month, the headline figure is expected to show continued moderation after touching a 40-year high of +9.1% in June. A preliminary look at November Michigan sentiment is also on tap, with the inflation component of the survey likely the market's primary focus.
Finally, 30 S&P 500 companies are scheduled to report third quarter earnings results this week, essentially closing the books on the market’s third quarter look-back. Notably, fourth quarter S&P 500 EPS estimates dropped 4.8% since the end of September, with analysts now expecting EPS growth to come in slightly negative in Q4. Similarly, first quarter 2023 S&P 500 EPS estimates dropped 3.6% since the end of September, suggesting analysts believe the challenges companies highlighted in their third quarter calls may carry over into the next few quarters. The question for investors: Have analysts taken down their earnings estimates enough?