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An ‘all-clear’ signal from the Fed appears to be wishful thinking



U.S. stocks posted strong gains last week during several choppy and volatile sessions. The S&P 500 (+4.7%) and the NASDAQ Composite (+5.2%) both rebounded last week after declining to their lowest levels since 2020 the week before. Both U.S. stock benchmarks posted their best week since June. On the week, Value (+4.0%) underperformed Growth (+5.4%), with Energy (+8.1%) and Technology (+6.5%) leading stocks higher. All eleven S&P 500 sectors finished the week with gains, though Utilities (+2.0%) and Consumer Staples (+2.2%) underperformed the broader S&P 500. However, the CBOE Volatility Index ended Friday just below 30, indicating stock volatility remains high and could keep equities trading in a wider range over the near term.

Across bonds, U.S. Treasury prices were mostly weaker, with the 2-year yield finishing the week a tick below 4.50% and the 10-year yield ending Friday’s session at 4.23%. While the quick surge in rates last week contributed to holding stocks back in the middle of the week, a Wall Street Journal article on Friday, noting the Federal Reserve might consider slowing the pace of rate hikes, as soon as December, helped provide a stock tailwind and temporarily cooled the surge in rates. However, messaging from the Fed on future rate hikes is likely to be very nuanced over future meetings. We expect Fed messaging to make continued references to data dependency, the need for a material drop in inflation to change policy, and reinforce a commitment to keep the door open for aggressive rate policy actions at future meetings. Bottom line: Friday’s surge higher across stock prices based on a Fed pause and hope for an all-clear signal that stocks can quickly return to an upward trajectory is simply wishful thinking on investors' part, in our view.

Without a significant drop in inflation, the Fed is likely to continue raising rates in 2023; bullish sentiment remains historically low

Interestingly, the market’s view of the terminal rate, or the rate at which the Fed finally stops raising its fed funds rate, topped 5.0% last week. That’s higher than where the Fed’s September dot plot indicated the highwater mark would hit just a few weeks ago. We believe the Fed will likely take its target rate higher by at least 125 basis points this year. And without a more material drop in inflation through the rest of this year, we suspect the door is still open for further rate hikes in 2023. From our vantage point, a Federal Reserve that remains almost singularly focused on cracking inflation’s back could keep stock volatility elevated and risk further economic weakness over the next six to nine months. We would chalk up most of last week’s rally to largely oversold market conditions and very weak sentiment, which tends to offer a short-term opportunity for strong stock bounces while still in the throes of a bear market.

Bullish sentiment across the American Association of Individual Investors Survey remains historically depressed. And at the same time, the number of S&P 500 stocks trading above their 50-day and 200-day moving averages remains well below their longer-term trend line. Data like this tends to offer traders a near-term buying excuse to be contrarian when stock conditions become so oversold as they had over recent weeks.

Outside of stocks and bonds, the U.S. Dollar Index was down 1.3% last week. British sterling posted another week of volatility, and Japanese officials again intervened to slow the yen’s decline versus the dollar. Gold finished the week near the flatline, and West Texas Intermediate (WTI) crude rose +0.5%, ending at $85.15.

The UK searches for a new prime minister; Q3 earnings appear stronger than expected

Overseas, Liz Truss resigned as UK Prime Minister after a hectic week, a disastrous fiscal budget plan, and a massive loss of confidence in her government. Truss’s 44-day premiership marked the shortest in UK history and was marred by a mistimed and ill-fated economic plan that looked to cut taxes and increase unfunded spending at a time of record high inflation. The Conservative Party is expected to announce the next UK Prime Minister this week. And in Asia, highlights from the 20th Communist National Party Congress in China likely disappointed investors if they were hoping for increased stimulus efforts. China President Xi Jinping secured a third term as Communist Party leader, stood by his zero-COVID policies, and stopped short of offering more fiscal support to help boost economic growth. And this week, the European Central Bank is expected to lift its target rate by 75 basis points, setting the stage for a similar move in December.
Back in the U.S., with roughly 20% of Q3’22 S&P 500 profit reports complete, blended earnings per share (EPS) growth is higher by +1.5% year-over-year on revenue growth of +8.5%. Thus far, 72% of S&P 500 companies have surpassed EPS estimates, while 70% have topped sales forecasts. However, according to FactSet, earnings growth is coming in at its lowest clip since the third quarter of 2020, and net profit margins are on pace to decline for a fifth straight quarter, though they remain high historically.

The early takeaways from the Q3 earnings season have come mainly from the banks, where net interest margins and net interest income have tended to come in stronger than expected and on the back of higher interest rates. Credit trends have remained firm, with solid consumer balance sheets helping to quell weakness in mortgages, investment banking, and merger and acquisition activity. Consumer staples companies and airlines continue to see strong demand and an ability to hold pricing power, which has offset volume reductions. Notably, solid earnings reports from the big airlines appear to fit neatly with the continued theme of consumer spending shifting toward services from goods. Along with rate pressures and high inflation, spending on big-ticket goods has come down in Q3. And companies with more currency exposure have cited the stronger U.S. dollar as a headwind, which is likely to persist in Q4. Importantly, elevated macro uncertainty is a theme that has resonated across companies and industries so far.

Positive returns following steep market declines are likely, according to history (although historical performance does not guarantee future results)

Consider that earlier this month, the S&P 500 Index had fallen more than 25% from its January high and was off more than 25% year-to-date. However, based on history, the further the S&P 500 falls from a 52-week high water mark, the greater the chance for positive returns once a bear market trough is finally reached. According to Bespoke Investment Group, the more extreme the S&P 500’s decline from a 52-week high, the greater the probability the Index will be higher one year later. For example, Bespoke finds that when the S&P 500 falls 25% or more from a 52-week high (like now), the Index was higher one year later 93.5% of the time. However, the typical bear market going back to 1950 has posted an average S&P 500 decline of roughly 35%. Notably, Bespoke finds that when the S&P 500 has fallen 34% or more going back to the end of World War II, the Index was higher one year later 100% of the time. Of course, history is not a guarantee of future returns. But it’s nice to see history is more favorable to investors once they have endured more aggressive declines.

And let’s not forget all bear markets eventually end. Importantly, during most years, the S&P 500 finishes a calendar year higher than where it started the year. Unfortunately, 2022, like a handful of other years throughout history, is unlikely to be a year that the S&P 500 finishes with a gain. But moving forward, the Index should return to a positive track at some point. The key for investors is not to get derailed while stocks remain off their usual upward-sloping course.

Looking ahead this week, the third quarter earnings calendar kicks into high gear, with Big Tech likely to dominate the headlines. Alphabet, Microsoft, Meta Platforms, Amazon, and Apple all report their Q3 results this week. In all, 165 S&P 500 companies, or roughly one-third of the Index, are scheduled to release their results over the next five days.

In addition to the heavy earnings slate, investors will get a first look at S&P Global Manufacturing and Services Purchasing Managers’ Indexes for October. Both measures of U.S. economic activity are expected to show only modest changes from September. Home data, including the S&P Case-Shiller National Home Price Index, September new home sales, and September pending home sales, are on tap throughout the week. Also, October consumer confidence, final October Michigan Sentiment, and a September look at the Fed’s preferred inflation measure, the Personal Consumption Expenditure (PCE) Index, will be key economic releases during the week.

Finally, the Bureau of Economic Analysis will release its first look at Q3 GDP on Thursday. FactSet estimates suggest the U.S. economy grew +1.9% quarter-over-quarter annualized after shrinking by 1.6% and 0.6% during the year's first two quarters.

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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