Stocks and bonds rallied in unison last week, thanks largely to comments from Fed Chair Jerome Powell on Wednesday afternoon. Speaking at the Brookings Institute, Powell confirmed that the Fed might slow the pace of rate hikes as soon as the December FOMC meeting. Investors interpreted that to mean that the days of 75bp hikes were over. Futures markets quickly crystalized around a 50bp hike in December, and lowered the expected number of 25bp rate hikes in 1Q23 from 3 to 2.
The impact on bond prices was significant, bringing welcome relief to battered investment grade bondholders. The Treasury yield curve experienced a parallel shift lower by 18-19bp over the course of the week, and credit spreads compressed slightly, extending the tightening trend that began in mid-October. Yields on IG corporates have fallen by roughly 100bp in that time.
Equities got a boost from Powell’s comments as well, particularly rate-sensitive growth stocks in the tech, consumer, and communications sectors. Dividend payers lagged the rally, particularly financials and energy as rates and oil prices dropped, respectively. Meanwhile, Chinese equities continued to move higher on hopes that public unrest would accelerate the removal of Beijing’s “Zero Covid” policy.
Economic news was abundant last week. Housing metrics (prices, sales) were weak, manufacturing gauges point to a contraction in activity, and consumer confidence waned a bit. On the flip side, despite rising unemployment claims and a reduction in open jobs, the monthly nonfarm payroll report came in above expectations at +263k (see the Chart of the Week), while unemployment held steady at 3.7%.
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 17.5x 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 2 additional 25bp hikes in 2023, with a “terminal” Fed Funds rate slightly below 5% for this cycle.
After reaching 40yr highs in spring of 2022, inflation has begun to moderate in recent months. Headline inflation eased over the summer on falling energy prices, and core inflation has followed suit in Q4. Goods inflation has fallen due to softening demand and excess inventory, while heavily lagged housing data is helping to keep services inflation elevated.