Last week’s main event was the November FOMC meeting, which concluded with the 75bp rate hike that everyone knew was coming. What was less obvious in advance was whether the Fed would communicate an intent to slow the pace of future rate hikes, potentially as soon as next month’s meeting. On that front, the market was initially excited about the reference to “the lags with which monetary policy affects economic activity and inflation” in the press release. Equities jumped and rates fell. But about an hour later, Fed Chair Jerome Powell stepped to the press conference microphone and made it very clear that even if the pace of hikes slows in the not-too-distant future, rates would probably rise higher and remain high for longer than the Fed and market participants had previously expected.
Once the Fed’s outlook was fully understood, markets quickly reversed course. Rates moved higher, the yield curve inversion deepened, and the “terminal” Fed Funds rate (the point at which the market expects the Fed to stop hiking) was pushed solidly above 5%. US equities fell, particularly longer duration growth stocks as the Nasdaq significantly underperformed. International benchmarks were buoyed by an 11% gain in Chinese stocks, driven by the approval of Pfizer’s mRNA vaccine for foreign residents and speculation that Beijing may reconsider its Zero Covid policy.
The week concluded with the BLS’s monthly jobs report, which had a Goldilocks feel. Job growth continues in the US, but the pace has clearly moderated relative to the first half of the year (see the Chart of the Week for a time series). Unemployment (U3=3.7%) and underemployment (U6=6.8%) ticked higher sequentially, a welcome development for a Fed that is working hard to cool an overheated labor market.
Albion’s “Four Pillars”
Economy & Earnings
US GDP rebounded to +2.6% in Q3 after falling in 1H22, and corporate operating margins remain solid at ~12% on the S&P 500. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.
The S&P 500’s forward P/E of 16x is slightly above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of this year’s P/E multiple compression has been driven by rates, rather than an expansion of the equity risk premium.
Rates have risen across the curve in 2022 in response to a shift in monetary policy. Fed Fund Futures are pricing +50bp in December and 3 additional 25bp hikes in 2023, with a “terminal” Fed Funds rate above 5% for this cycle.
Inflation is at 40yr highs as supply chain disruptions, labor shortages, and rising energy prices have impacted input costs for many businesses. Headline inflation eased lower over the summer thanks to falling energy prices, but core inflation reaccelerated sequentially in August & September.