What happened?

The S&P 500 rallied 3.1% on Wednesday after Federal Reserve Chair Jerome Powell signaled a likely downshift in the pace of rate hikes, which he said “may come as soon as the December meeting.”

After four consecutive 75-basis-point increases, markets are now pricing a 50bps hike from the Fed in December. However, market pricing of the terminal rate was little changed on Wednesday. The May 2023 fed funds futures contract was down only 7bps to 4.93%.

The 10-year Treasury yield fell 14bps to 3.6%, while the 2-year yield declined 16bps to 4.31%. The DXY dollar index fell 0.8%.

Data released on Wednesday supported the view of a slowly cooling labor market. JOLTS job openings fell by 353,000 to 10.3 million in October. ADP data showed that private payrolls expanded by 127,000 in November, less than the 200,000 expected.

Earlier in the day, the Euro Stoxx 50 closed 0.8% higher after Eurozone inflation fell by more than expected. Consumer price inflation slowed to 10% in November from 10.6% in October.

What do we expect?

Powell’s speech at the Brookings Institution on Wednesday was less hawkish than some investors had feared, giving further impetus to a rally that has lifted the S&P 500 by around 13% from its October low. Hopes of less aggressive Fed policy, along with investor flows and positioning, have driven the market rebound, and Powell did not push back against it.

The Fed chair acknowledged that several of the major drivers of inflation―including production bottlenecks and goods price inflation―are easing. Although housing services inflation is likely to continue rising in the coming months, it should also begin to fall “later next year.”

While these are encouraging developments, Powell also noted that the US labor market shows “only tentative signs of rebalancing,” and wage growth remains “well above the levels that would be consistent with 2% inflation over time.” Friday’s nonfarm payrolls report is expected to show job growth slowing to 200,000 in November from 261,000 in October, with the unemployment rate forecast to remain just above a 50-year-low at 3.7%.

We maintain our view that the Fed will hike rates by 50bps in December and another 50bps in 1Q23, bringing the hiking cycle to an end. However, the cumulative impact of prior rate rises will continue to weigh on economic growth and corporate profits. The minutes of the FOMC’s November meeting showed that Fed staff view the chances of the US economy going into recession over the next year as “almost as likely as the baseline” of it narrowly avoiding one.

This slowdown will take a toll on S&P 500 earnings, which we expect to contract by 4% in 2023. Bottom-up consensus earnings per share (EPS) growth expectations are currently 5%, which may be too optimistic. Tighter lending standards, likely further declines in the ISM Manufacturing index, and the Fed’s expectations that the unemployment rate will rise suggest that EPS will fall next year.

How do we invest?

Despite the recent rebound in equities, we do not think the macroeconomic preconditions for a sustained market rally are yet in place. We view the risk-reward outlook for the next three to six months as unfavorable, but given the prospect of periodic rallies, we favor strategies that add downside protection while also retaining upside exposure.

We recommend focusing on the more defensive areas of each asset class. Within equities, we like capital protection strategies and quality-income stocks, along with the healthcare and consumer staples sectors, which should be relatively resilient as economic growth slows. In currencies, we like the safe-haven US dollar and Swiss franc relative to sterling and the euro, while in fixed income we prefer high-quality and investment grade bonds relative to US high yield.

With inflation still well above central banks’ targets, we also expect value stocks to outperform growth stocks, and energy is one of our preferred global equity sectors. Regionally, we like the cheaper and value-oriented UK and Australian equity markets relative to US equities, which have a higher exposure to technology and growth stocks, and where valuations are higher.

Meanwhile, high equity-bond correlations this year have underlined the importance of seeking alternative sources of return, for example in certain hedge fund strategies. Macro strategies have been particularly strong performers in 2022, and we expect them to continue to fare well in volatile markets.