The rapid repricing of equities and fixed income in the days ahead of the Federal Open Market Committee (FOMC) meeting today suggested that market participants were bracing for the worst. What the Fed delivered was more or less in line with expectations – the 75 bp rate increase itself was fully baked in, while the terminal rate of 4.6% is only slightly above prior market expectations.1 Another 100 to 125 bps of rate increases by the end of the year was also largely as predicted, since many Fed watchers had raised their November and December rate hike expectations prior to this meeting to 50 bps from the 25 bps they had penciled in previously.2
The markets still sold off sharply into the close because, as we expected, Fed Chair Powell made it obvious that to decisively bring down inflation the Fed is willing to tolerate slower growth and higher unemployment than previously thought. This realization, alongside short-term rates now north of 4% (See Exhibit 1), have significant implications for where to find relative value in these markets.3 In this week’s commentary we discuss why, even after the latest pullback and despite the potential for a near-term rebound, equities are unlikely to regain their relative attractiveness in the short term given the highest rates since 2007 are probably here to stay for the foreseeable future.
A hawkish stance we expected
Although the markets were clearly not surprised by today’s Fed decision, the committee’s commitment to fighting inflation with higher rates was reaffirmed and strengthened.
In recent weeks, and especially in light of last week’s stunner of an inflation print, it was increasingly clear that the Fed’s patience with stubbornly high inflation was wearing thin and the likely sentiment during the committee discussion was they that they are not doing enough, quickly enough to bring it down. Case in point – economic data is slowing but the labor market is resilient4, while the government is still adding incremental fiscal stimulus via programs like student loan forgiveness.
The committee therefore needed to deliver a resolute decision – to extinguish inflation, they will likely have to crack the labor market. Indeed, September’s dot plot showed forecasts for the 2023 unemployment rate rising to 4.4% from 3.9% in prior June projections.5 Since job losses are now on the table, it seems that the Fed is willing to abandon hopes for a soft landing to achieve its inflation objective and market expectations for recession will strengthen.
Today’s decision makes it 100% clear that the Fed is going to steadfastly fight inflation and a solid piece of market advice is “don’t fight the Fed”. This hawkish stance in turn changes the relative value calculus for equity investors.
Relative value of equities continues to decline
The U.S. 2-year Treasury note touched 4% on Wednesday, a level not seen since October of 2007 – an attractive yield for a nearly risk-free instrument.6 With the terminal value for the fed funds rate – the high point in a rate hiking cycle – now expected to be 4.6% in 2023 and core personal consumption expenditures inflation forecasted to be 4.5% in 2022, declining to 3.1% in 2023, the expected real rate may finally turn positive.7 This affects the relative value of stocks versus bonds.
One way to assess this is to look at the difference between the forward earnings yields on the S&P 500 and the yield on the U.S. 10-year Treasury. Over the last few months, this spread has deteriorated and is currently just 2.21% – below both the five- and ten-year averages of 3.17% and 3.51%, respectively, and in stark contrast to the 14 years since the global financial crisis (GFC), during which this spread had consistently and significantly exceeded the 30-year average of 1.97%.8
Thus, investors’ reasonable assumption since the GFC – that equities are more attractive than bonds – might need to be revisited. The worsening relative value of equities suggests their potential for outperformance is limited, at least in the foreseeable future.
Investors have grown accustomed to buying every dip and have continued to do so this year, but one difference is that there appears to be little FOMO (fear of missing out) in the market right now, with lots of cash on the sidelines.9 Long-only managers now have north of $200bn in cash, which marks the highest absolute dollar value since 2006 when data was first compiled.10 There is no compelling reason to chase equities higher when 4% rates will likely hurt economic growth and prompt further downward earnings revisions. A Fed pivot cannot be counted on just yet and, at 17x forward price-to-earnings (P/E) multiples, S&P 500 equities are not yet “dirt cheap”.11
Full pricing in of recession probabilities required to buy equities with confidence
What would change that? Equity valuations would need to reach “dirt cheap” levels to lure investors back in. Given rising recession probabilities (one-year recession probability has risen to 49% from economic indicators, while the two-year probability is even higher at 74%12 ) amidst renewed Fed hawkishness, we would look for a full pricing in of these recession probabilities before real value emerges. This could require S&P 500 forward P/E multiples returning to levels last seen during the COVID-induced dip in 2020 at about 14x-15x (See Exhibit 3).13
Of course, eventual Fed rate cuts would support equities, but we are not yet in the camp that believes rate cuts will start in 2023, and clearly the Fed is not either. With monthly inflation data continuing to whipsaw and the latest month-over-month increase of 0.6% not yet suggesting a fall in year-over-year inflation14 , for now we have to assume that the Fed is not yet done fighting inflation.
The bottom line is that it seems to us that something needs to break first before it will be time to pick up the pieces. It is possible that this will be later this year or early next.
Until then, we expect to see tactical rallies from oversold levels – and we might see that soon – and it is certainly okay to add some risk when we are near the bottom of the recent 3,800-4,300 trading range. However, we would not move aggressively into full risk-on equities just yet, as anything without a yield is going to have a very hard time competing with cash or other yield options in an economy that is slowing and a labor market that will have to weaken.
We continue to focus our investment strategy on “getting paid while you wait”. We would be adding short-duration U.S. Treasuries and municipal bonds to capture the newly elevated yields of close to 4%.15 Certificates of deposit paying roughly 4% should also be back in vogue.16 A barbell strategy of safe-haven assets like these alongside higher-yielding credit risk makes sense. In equities, in addition to adding to energy, which has been a top performer this quarter, a top dividend-yielder, and one of our favorite sectors, we would look to find value in multi-family residential real estate, a sector with strong fundamentals, competitive yields, and inflation-protection characteristics.17
(1) Source: Bloomberg, Federal Reserve Summary of Economic Projections, as of September 21, 2022.
(2) Source: Bloomberg, as of September 21, 2022.
(3) Source: Bloomberg, iCapital Investment Strategy, as of September 21, 2022.
(4) Source: Bloomberg, iCapital Investment Strategy, as of September 21, 2022.
(5) Source: Federal Reserve Summary of Economic Projections, as of September 21, 2022.
(6) Source: Bloomberg, iCapital Investment Strategy, as of September 21, 2022.
(7) Source: Federal Reserve Summary of Economic Projections, as of September 21, 2022.
(8) Source: Bloomberg, iCapital Investment Strategy, as of September 21, 2022.
(9) Source: Goldman Sachs, as of September 20, 2022.
(10) Source: Goldman Sachs, as of September 20, 2022.
(11) Source: Bloomberg, iCapital Investment Strategy, as of September 21, 2022.
(12) Source: JPMorgan, as of September 20, 2022.
(13) Source: Bloomberg, iCapital Investment Strategy, as of September 21, 2022.
(14) Source: Bloomberg, iCapital Investment Strategy, as of September 21, 2022.
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