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Will the Fed use Jackson Hole to reset market expectations?

ANTHONY SAGLIMBENE – CHIEF MARKET STRATEGIST, AMERIPRISE FINANCIAL
WEEKLY MARKETS COMMENTARY — August 22, 2022

 

Stocks snapped a four-week winning streak after the July Federal Open Market Committee (FOMC) meeting minutes poured cold water on the idea that the Federal Reserve is readying a position to slow rate hikes. The S&P 500 Index lost 1.2% on the week, while the NASDAQ Composite fell 2.6%. Growth underperformed Value for the second consecutive week, and Retail, down 2.8%, lost ground despite a few Q2 earnings reports showing continued strength among consumers. The Dow Jones Industrials Average closed the week lower by 0.2%, and the Russell 2000 Index finished down 2.9%.

Given the weaker performance across major U.S. stock averages last week, Consumer Staples (+1.9%) and Utilities (+1.2%) outperformed. Communication Services (down 3.3%) and Materials (down 2.5%) lagged. Gold ended the week lower by 2.9%, and West Texas Intermediate (WTI) crude finished lower by 1.8%, falling to levels last seen in January.

The stock and bond markets continue to predict different outcomes from current conditions

U.S. Treasury performance last week was mostly weaker, with the yield curve steepening. The 2-year/10-year U.S. Treasury spread narrowed its inversion to around 25 basis points, down from more than 40 basis points the following week. By the end of last week, the yield on the 2-year U.S. Treasury stood at 3.23%, while the 10-year U.S. Treasury yielded 2.97%. 

Under normal conditions, investors should expect to receive a higher yield on money tied up for longer. Simply, shorter-duration Treasuries outyield longer-dated Treasuries today because investors believe the Federal Reserve will likely need to aggressively raise its fed funds target rate over the near term to fight inflation. At the same time, investors also believe this period of high inflation will likely subside over time, allowing Fed policy and interest rates to return to more normal levels — hence the lower yield on the 10-year Treasury today versus the 2-year.  

However, inversions across the yield curve are rare and can signal economic weakness ahead. Although not every Treasury inversion leads to an economic downturn or recession, the duration of the current inversion is growing more concerning, in our view. For example, the 2-year/10-year curve has remained inverted since early July, and the 3-Month/10-year Treasury spread (a more reliable recession indicator) has narrowed by over 190 basis points this year. And while the 3-Month/10-year curve is currently positive by roughly 36 basis points, a turn into negative territory would be concerning. A negative 3-Month/10-year curve could signal further economic weakness, tighter financial conditions, and the possibility that the Federal Reserve could raise its target rate to a level that restricts economic growth and causes a recession.

Understandably, most investors typically don’t spend much time digging into yield curve inversions and how they tie to signals in the economy. However, we highlight the factor because we believe the unusual occurrence is a good example of how the stock and bond markets interpret current conditions differently and what they might imply for asset prices moving forward. In general, the bond market is currently signaling rougher waters ahead, a higher recession probability, and a more cautious attitude about rate policy. Conversely, the S&P 500’s +16.3% rally off its mid-June low signals stock investors appear more willing to look through the high inflation environment, a near-term slowdown, and see an opportunity for rate pressures to subside next year. While both views can be correct over time, the magnitude of change in rates and economic growth over the coming quarters are the two variables that could matter most to how assets perform over the intermediate term. Which side is geared correctly in foreshadowing the direction for asset prices through year-end remains an open question.

Notably, the July FOMC minutes reiterated the Fed’s heightened attention to incoming data and how it would influence the path and magnitude of rate hikes moving forward. Commentary pointed to the need to raise policy rates to a “sufficiently restrictive” level to control inflation, and rates may need to remain at that restrictive level “for some time.” Combined with commentary during the week from Fed voting members suggesting the central bank has more work to do to bring inflation down, market participants began to walk back the idea of a less hawkish Fed, which had helped lift stock prices for a number of weeks. We expect Fed officials to drive home a more hawkish tone at the annual Jackson Hole Economic Symposium this week and before its late September policy meeting. Most market participants see the Fed raising rates by 50 basis points next month. We’ll see if that remains the case after Jackson Hole.

Bear bounce or market rally? It’s still too early to tell

Also weighing on stock sentiment last week were growing concerns that the rally is nothing more than a typical bear market bounce. Further downward revisions to earnings estimates and stretched valuations kept American Association of Individual Investors (AAII) bullish sentiment below its longer-term average for the 39th consecutive week.

Though the S&P 500 was able to touch its 200-day moving average intra-day early last week, the threshold provided immediate resistance on the heels of near-term overbought conditions across the Index in key technical indicators. At one point during the week, over 90% of S&P 500 stocks were trading above their 50-day moving average, following roughly just 2% of the Index trading above that threshold in mid-June. However, forward returns for stocks over the next year tend to be above average when breadth to the upside is this strong, according to data from Bespoke Investment Group. This helps counter the idea that the market is predestined to give back its recent winnings, despite valuation concerns, with the S&P 500 tending to be higher more times than not over the next year after such periods of strong gains. With that said, second-half 2022 and full-year 2023 S&P 500 earnings per share (EPS) estimates continued to decline during the week. Though estimates still point to positive profit results ahead, the downward trajectory could continue to erode market confidence. 

In other highlights last week, July retail sales fell 0.8% month-over-month, missing the +0.2% increase expected, driven by lower gasoline station sales. However, the control group showed a m/m increase of +0.8% in July, more than the +0.4% expected, demonstrating consumer spending remains resilient despite inflationary pressures. In addition, existing home sales last month slowed to their weakest pace since June 2020, and the August National Association of Home Builders housing market index posted its lowest point since May 2020. Higher interest rates and high home prices are clearly dampening sentiment and demand.

Lastly, a batch of retail earnings from last week provided a mixed bag of takeaways. On the one hand, some reports pointed to retailers taking actions to reduce excess inventories, still healthy consumer trends, and strength in professional segments of housing retailers. But, on the other hand, consumers trading down, weakness in do-it-yourself housing categories, and high inflation eroding demand across discretionary goods are headwinds that could remain persistent throughout the year.

The Fed’s Jackson Hole event will dominate the economic news cycle this week

Looking ahead to this week, investors are likely to key in on Federal Reserve speeches and presentations out of this year’s Jackson Hole event for signs of policy direction. Fed Chair Powell will speak on Friday. This year’s topic is “Reassessing Constraints on the Economy and Policy,” which is timely given that most central banks in the developed world have done a 180-degree turn in policy from extreme accommodation to raising rates aggressively to fight inflation. However, we believe markets began to price in last week a more hawkish policy tone out of this year’s symposium, fading expectations for potentially easier policy later this year. In our view, the market will be more interested in what can be drawn from the event about a potential policy pivot in the first half of 2023, mainly if economic growth is weak or the U.S. economy is in a recession.

During the upcoming week, investors will be busy dissecting August preliminary Markit Purchasng Managers’ Index (PMI) reports on manufacturing and services activity, July new and pending home sales, July durable orders, and July Personal Consumption Expenditures (PCE) inflation data. A second look at Q2 GDP on Thursday is expected to remain unchanged at -0.9% quarter-over-quarter annualized.
 

Sources: FactSet and Bloomberg. FactSet and Bloomberg are independent investment research companies that compile and provide financial data and analytics to firms and investment professionals such as Ameriprise Financial and its analysts. They are not affiliated with Ameriprise Financial, Inc.

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