Last week’s main event was the December FOMC meeting. As expected, the Fed raised overnight interest rates by 50bp, bringing the final tally for 2022 to 425bp of increases since “lift-off” in March. But despite better-than-expected CPI data that was released earlier in the week, Jerome Powell’s inflation-fighting rhetoric was as hawkish as ever, dampening equity investors’ hopes of a more dovish Fed in 2023.
The Fed’s impact on equity trading was very obvious last week. From Monday’s open through 2:00 pm on Wednesday (the time of the Fed’s rate decision and press release), the S&P 500 rose nearly 3% thanks to the aforementioned moderation in the inflation trend. But from the conclusion of the FOMC meeting through Friday’s close, the index fell nearly 5%, to finish down 2% overall on the week. Most other domestic and international equity benchmarks experienced similar declines.
Meanwhile, the bond market’s response suggested that investors are becoming less concerned about inflation, and more concerned about a Fed-induced recession. Fed Fund Futures markets continue to undershoot the Fed’s own interest rate projections (see the updated Dot Plot below), and Treasury yields fell across the curve following the FOMC meeting, pushing bond prices higher.
Apart from the Fed and inflation, most of last week’s incoming data suggested a slowing economy. Retail sales fell 0.6% sequentially in November, while Industrial Production and Capacity Utilization both fell by 20bp. Meanwhile, the Empire Manufacturing (-11.2) and Philly Fed (-13.8) surveys both sunk deeper into contraction territory in the December prints, as did S&P’s US Manufacturing (46.2), Services (44.4), and Composite (44.6) PMIs.
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 17x 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 in two 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.