Weekly Recap

Stocks and bonds alike staged a strong rally after October CPI data came in below expectations by 20bp across the board:

• Headline CPI was +0.4% m/m and fell to +7.7% y/y
• Core (ex food & energy) CPI was +0.3% m/m and +6.3% y/y

The sequential drop in core CPI was the primary focus of market participants, as it reflects real time inflation dynamics without the volatile impact of food and energy prices. Goods inflation has moved lower as supply chain bottlenecks have eased, leaving services inflation as the primary driver. See the Chart of the Week for a time series of recent m/m prints of the CPI Services component.

Investors responded by immediately removing one full 25bp rate hike from its calculus regarding the forward path of Fed policy, with the reduction relative to previous expectations coming in early 2023 (a 50bp hike is still priced for the December FOMC meeting).

The Treasury curve followed suit, with yields falling in excess of 30bp from the 1y to 10y point, while long bond (30y) yields were down by nearly 25bp as well. Credit spreads continued to drift tighter as well, to the benefit of corporate bonds.

Equity markets responded to the improved inflation / interest rate outlook by moving sharply higher. Returns were generally ordered by duration, with tech and other growth stocks outperforming while higher dividend paying sectors lagged.

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.

Valuation

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.

Interest Rates

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 of 4.75-5.0% for this cycle.

Inflation

Inflation is near 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, and core inflation decelerated in October.

Weekly Recap

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.

Valuation

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.

Interest Rates

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

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.

Weekly Recap

US equities moved sharply higher for a second straight week as investors increasingly became confident that the upcoming November FOMC meeting could represent the last of the 75bp rate hikes. The only sector in the S&P 500 to finish lower was Communications, which was dragged down by a 23.7% decline in META after very disappointing Q3 earnings. Softer digital ad revenue also impacted Alphabet (Google) in the quarter. Q3 earnings season thus far has been mixed, with y/y earnings growth running at just +2% overall (-5% excluding the energy sector).

International stocks were higher as well, with one exception: China. By the end of the 20th China Party Congress, Xi Jinping had solidified his power and made it clear that Chinese companies would continue to see strict oversight under his rule. The MSCI China Index bucked the global trend and dropped 9% on the week.

Bond markets rallied as rates fell in the belly and long end, deepening the inversion. Notably, the 3m/10y curve point finally inverted for the first time in this cycle as well, as the Fed gradually catches up to what has been priced into the Treasury curve for some time now. Credit spreads tightened marginally.

Economic news last week was mixed. Consumer confidence fell and initial jobless claims rose. Mortgage rates topped 7% in the US for the first time since early 2002, while new and existing home sales slowed and home prices fell. Durable goods orders missed expectations, while S&P’s US Manufacturing PMI slipped below 50 and into contraction territory. However, Q3 GDP came in at a robust +2.6% thanks to a rebound in net trade and a resilient US consumer.

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.

Valuation

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.

Interest Rates

Rates have risen across the curve in 2022 in response to a shift in monetary policy. Fed Fund Futures are pricing in +75bp in November and +50bp in December, with an implied Fed Funds target rate floor of 4.25% by year end.

Inflation

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.

Weekly Recap

Domestic financial markets adopted a strong risk-on tone last week, with the Treasury curve steepening while US equities rallied. Investors appeared to take some comfort from Q3 earnings being less bad than feared thus far, and also in comments from Fed governors that reinforced what futures markets were already predicting, namely a relatively neutral policy stance in 2023 (data permitting).

With some investors taking recession bets off the table, the Treasury yield curve steepened as 2y yields fell 3bp while 10y and 30y yields increased 20bp and 34bp respectively. By Friday’s close, slightly less than half (22 out of 45) Treasury curve points were inverted, down from nearly 65% (29 out of 45) the prior week. Interestingly, the bullish tone in Treasuries was not matched by IG credit spreads, which remained stubbornly wide at 151bp, essentially unchanged on the week.

Equities did embrace the risk-on tone, however, with US large caps rocketing higher by roughly 5% in aggregate. Small and midcap stocks registered meaningful yet slightly smaller gains. International equities lagged but still finished in the green.

Economic data released last week was mixed. Housing starts fell sharply while residential building permits ticked up a hair. Empire Manufacturing and the Philly Fed Business Outlook both fell deeper into contraction territory, but Industrial Production rose 0.4% sequentially in September, beating expectations. Initial jobless claims fell, while continuing claims rose. Lastly, the Conference Board’s Leading Economic Index fell 0.4% sequentially and reach -1.4% on a y/y basis, a level that has always presaged an oncoming recession in the past (see Chart of the Week).

Albion’s “Four Pillars

Economy & Earnings

US GDP fell in Q1 (-1.6%) and in Q2 (-0.6%), but job creation was strong with 2.75mn NFP added in 1H22, and corporate operating margins were robust. Consensus calls for slow economic growth in 2H22, but companies have warned of inflation pressuring margins, and analysts have cut Q3 earnings estimates.

Valuation

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. That said, valuations for many growth companies are at or near decade-lows, suggesting forward returns in some sectors could be above average.

Interest Rates

Rates have risen across the curve in 2022 in response to a shift in monetary policy. Fed Fund Futures markets are pricing in a total of 17 25bp rate hikes in 2022, with an implied Fed Funds target rate floor of 4.25% by year end.

Inflation

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.

Weekly Recap

Stocks moved sharply higher at the start of Q4, with the S&P 500 posting a 4% gain in just two days to kick off the month of October, although the rally fizzled after Friday’s NFP report (more on that below). Cyclical sectors posted solid gains on the week despite the Friday swoon, while defensives lagged. Energy stocks shot higher following news that OPEC+ would cut production by 2 million barrels today in an effort to shore up oil prices in the face of flagging global demand.

Labor market data was mixed last week, with the Job Openings and Labor Turnover Survey (aka, “JOLTS”) showing a drop in available jobs in the US, from 11.2mn in August to a still elevated 10.1mn last month. Then on Thursday, initial jobless claims arrested a 7-week downtrend and moved higher, to 219k. These signs of weakness were not echoed in Friday’s monthly nonfarm payrolls report, however, potentially giving the Fed wide latitude to continue its aggressive stance on inflation.

Highlights of the monthly jobs report included:

• +263k nonfarm payrolls added (cons = +255k)
• 3.5% unemployment (down 20bp m/m, see the Chart of the Week for history)
• 6.7% underemployment (down 30bp m/m)

In response to the strong labor market data, futures markets have now solidly coalesced around a 4th straight 75bp rate hike at the November FOMC meeting, followed up by another 50bp at the December meeting, for a policy rate floor of 4.25% at year-end. Treasury yields also ticked higher last week as the curve steepened slightly.

Albion’s “Four Pillars”

Economy & Earnings

US GDP growth fell in Q1 (-1.6%) and in Q2 (-0.6%), but job creation remained strong in 1H22 with 2.75mn NFP added. Consensus calls for slow growth in 2H22. Operating margins remained robust in 1H22, but companies have warned that inflation could pressure margins going forward and analysts have cut Q3 earnings estimates.

Valuation

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. That said, valuations for many growth companies are at or near decade-lows, suggesting forward returns in some sectors could be above average.

Interest Rates

Rates have risen across the curve in 2022 in response to a shift in monetary policy. Fed Fund Futures markets are pricing in a total of 17 25bp rate hikes in 2022, with an implied Fed Funds target rate floor of 4.25% by year end.

Inflation

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 in July and August thanks to falling energy prices, but core inflation reaccelerated sequentially in the August print.

Weekly Recap

Rates rose anew and stock prices fell globally in the wake of Wednesday’s FOMC meeting. The updated Summary of Economic Projections showed weaker growth and higher unemployment in 2023 relative to the previous SEP release from three months ago, consistent with the notion that economic pain will be necessary in order to get inflation under control. Meanwhile, the updated Dot Plot demonstrated the Fed’s resolve in keeping rates “higher for longer”, with a median year-end 2023 Fed Funds projection of 4.625% and no sign of any “dovish pivot” prior to 2024.

With investor confidence already fragile, Friday’s poorly received budget from the new UK government provided a fresh catalyst for another leg lower. The proposal featured a raft of deficit-financed tax cuts aimed at raising economic growth to a sustained 2.5% annual rate, drawing immediate comparisons to Anthony Barber’s 1972 budget that led to a highly inflationary boom/bust cycle and eventually an IMF bailout for the UK. Economic growth of that magnitude has not occurred in the UK in 15 years, and appears highly ambitious (if not outright unrealistic) given the country’s ~0.5% population growth rate and its departure from the EU.

In US economic news, incoming data continue to suggest that the probability of recession in the coming months is very high. New residential building permits fell sharply once again as the housing market slows, moving the indicator from green to yellow on Albion’s key leading indicator dashboard. Meanwhile, the Conference Board’s Leading Economic Index (LEI) fell sequentially for the 6th straight month and is now at -1% on a y/y basis, a level that historically has indicated a near certainty of imminent recession.

Albion’s “Four Pillars”

Economy & Earnings

US GDP growth fell in Q1 (-1.6%) and in Q2 (-0.6%), but job creation remained strong in 1H22 with 2.75mn NFP added. Consensus calls for slow growth in 2H22 despite weak consumer confidence and softer housing and labor markets. Corporate operating margins remained robust in 1H22, but many companies have warned that inflation could pressure margins going forward.

Valuation

The S&P 500’s forward P/E of 16x is slightly above the long run average, and more predictive valuation 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.

Interest Rates

Rates have risen across the curve in 2022 in response to a shift in monetary policy. Fed Fund Futures markets are pricing in a total of 17 25bp rate hikes in 2022, with an implied Fed Funds target rate floor of 4.25% by year end.

Inflation

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 in July and August thanks to falling energy prices, but core inflation reaccelerated sequentially in the August print.