Slower Fed, soft landing ahead? As we close out a volatile year, investors eagerly search for clues of falling inflation and a more dovish central bank.

Another wild month for the markets concluded with the S&P 500 gaining another 5% in November, building on October’s momentum. The equity markets registered back-to-back monthly gains for the first time since August 2021. The higher performance was almost entirely driven by Fed Chairman Jerome Powell’s Q&A appearance and a pair of inflation reports - lower than expected CPI (consumer price index) and PPI (producer price index) prints, with the former being a biggest driver. The midterm elections that are now behind us, providing more certainty by way of gridlock, did not hurt the cause.

October feels like a year ago, considering the elections and the parabolic market movement immediately following just a small decrease in overall consumer and producer inflation. In fact, November 10-11^th was the best two-day performance for the stock market in two years.

Why the excitement? While far from the Fed’s target, or anywhere near acceptable as a terminal rate, 7.7% headline inflation finally showed that the monetary policy medicine might be working. In other words, inflation appears to have peaked and is moving downward. US Treasuries were notably stronger, with the mid to long end of the yield curve falling dramatically.

November jobs report surprise

Then came the November jobs report released on December 2^nd that spoke to just how tight the labor market is. Wages and job gains were a big surprise to the upside, with overall wages increasing .6% month-over-month and 261k jobs added, well above estimates.

The unemployment rate stayed steady at 3.7%. It was an odd report to say the least, as “whisper” numbers were way off compared to the released figures. Parsing through the data, service jobs were added in droves with the largest gains in leisure & hospitality and healthcare. The retail sector lost jobs, an unusual development right before the holiday season. The report highlights just how robust the services sector is and how much less people are spending on goods.

The jobs report was positive for the economy, but not the best news for the markets, with investors quietly hoping for a Fed pivot in interest rate hikes or at least a slowdown in the speed and size of those hikes. That’s the big item on investor’s holiday wish list and the Fed can deliver on that with a 50 (.5%) or 25 basis point rate hike after their mid-December meeting. It would break the current jumbo sized 75 basis point rate hike trend, signaling that the Fed may want to slow down and assess the damage, so-to-speak. A higher-than-expected inflation report in December along with the recent jobs data would threaten the “soft landing” narrative.

The employment data is still far too strong for the Fed to pause. The jobs report, while positive, flew in the face of the Fed’s efforts to slow the economy and stubborn inflation. Speaking of the employment picture, a potentially disastrous rail strike was averted at the 11^th hour, when congress passed a bill that would enforce the terms of a contract negotiation forged in September between unions and freight railroads. This prevents even further severe supply chain disruptions for necessary goods.

Bonds as a buffer for recession volatility

If the central bank can slow the rate hikes or even pause, it would be great news (given declining inflation) not just for stock investors, but maybe even more so for bond investors, especially those looking to invest at longer maturities. Short term rates are likely to continue to rise, but we have been optimistic about a potential peak in the US 10-year Treasury rate as we have lengthened our duration and added direct intermediate and longer dated bond maturity exposure to our portfolios.

The longer dated exposure has turned out well as the 10-year US Treasury yield remarkably fell from 4.2% to around 3.6% over the past month. These long-term rate decreases are in stark contrast to short term rates rising from anticipated Fed rate movements.

The US Treasury bond yield curve has not been this inverted since 1981, meaning the widest negative spread between the two- and ten-year Treasury bond yields in decades. That is significant, because in a normal market, bond maturities in the intermediate-to-longer term reflect growth and inflation, carrying a “term” premium (at least in theory) that compensates investors for interest rate risk. When the difference in short term rates versus long term rates turns negative and decidedly so, it is a strong signal that the bond market anticipates declining growth and inflation and the Fed will eventually lower interest rates.

What does this mean for investors overall?

The bond market is emphatically singing a recession song, but the stock market may be whistling past the graveyard. Retail investors seem to be afraid of jumping back into bonds given the backdrop of rising rates, but with interest rates topping out sooner or later with slower expected growth, institutional investors are really starting to lock in the higher rates at longer maturities. This is evident in how intermediate to long term yields have been falling (yields fall, bond prices increase).

Reinvestment risk is supplanting interest rate risk as potentially the chief concern. Investment grade bonds in general appear to have more opportunity as they are more of a natural place to park money in a global slowdown. We still believe the natural ceiling for the target Fed policy overnight rate is somewhere in the 5% range. Yet, the stock market has continued to rally quite a bit, even internationally, despite ongoing risk and headwinds.

Keep an eye on top line growth and earnings for margin erosion

The real risk for the stock markets going forward outside of any further inflationary shocks, is earnings compression from lack of demand and persistent higher costs. Inflation may ease, but if the Fed is successful, they will have reduced consumer demand to sufficiently stabilize prices and that may mean lower bottom line growth for many companies.

If margins start to flatline or even decrease, it could be quite damaging to stock prices given that, with the bear market rally, valuations are even more expensive than a few months ago. The broad US stock market is just around 16% lower than all-time highs, although many big tech stocks have not recovered nearly as much. The NASDAQ composite index is still down 29% on the year. This is where being very picky with asset class and style box selection comes in handy.

It will be paramount to keep valuations top of mind.

Value, low volatility, and profitability are still the focus for stocks in our view going forward. Headlines have been painting a picture of falling discretionary goods prices and a large increase in credit card usage. Corporate managers have noted a focus on corporate cost-cutting, layoffs, and housing market risk from higher mortgage rates. Geopolitical risks may have only grown with protests in China over COVID lockdowns, Russia’s ongoing bombardment of Ukraine, and European economic weakness. Looking forward, we will keep watch for holiday spending data, November’s inflation report, and the last Fed meeting until early February.

New Year, New Opportunities

As we enter 2023, it’s important to note that it’s been an historic and difficult year by all accounts for both global financial assets and the real economy. It is said that the strongest steel is forged by the hottest fires. For all of the adversity and stresses that the world and the financial markets have faced throughout the year, there have been healthy developments. Bonds are becoming bonds again, excesses are being removed, and various discounts and opportunities for stock ownership at a reasonable price now exist. There is always reason for optimism and here’s to a more fruitful, hopefully less volatile, prosperous, and healthy 2023. Happy Holidays and Happy New Year!

Questions? Comments? Contact us.

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