The Fed outlined more pessimistic forecasts for unemployment, which they now see rising to 4.6% next year, up from a projection of 4.4%. (ddp)

While the Fed slowed the pace of tightening, raising rates by 50 basis points after four consecutive 75bps hikes, the median forecast from policymakers is that rates will peak around 5.1%—half a percentage point more than they were projecting in September.

At a press conference following the announcement, Fed Chair Jerome Powell said the central bank still had “some ways to go.” While welcoming the slowing pace of inflation shown in the October and November data, Powell said that the Fed would require “substantially more evidence” before concluding that inflation was falling sustainably. Notably, he stressed the labor market was “extremely tight,” with “wage growth elevated” and at a level that was inconsistent with hitting the Fed’s 2% inflation target.

Meanwhile, the Fed outlined more pessimistic forecasts for unemployment, which they now see rising to 4.6% next year, up from a projection of 4.4%. They also scaled back expected economic growth from 1.2% for 2023 to just 0.5%.

However, the market reaction was relatively muted. The yield on the 2-year US Treasury was little changed at 4.24%, and now stands below the fed funds rate target range of between 4.25% and 4.5%. That suggests that investors still expect the Fed to become less hawkish. The DXY dollar index was also little changed.

The message from the Fed came the day after surprisingly tame inflation data for November. The core consumer price index (CPI), which excludes food and energy, rose 0.2% month-over-month, the slowest pace in over a year. The headline rate of inflation climbed 0.1% versus a consensus forecast by economists for 0.3%. That took the year-over-year rate down to 7.1%, the lowest since December 2021 and well below a high of 9.1% in June.

What do we think?

The FOMC meeting reinforces our view that the Fed does not yet believe its job is done with inflation. The dot plot pointed to a strong consensus among policymakers for at least a further 50bps of tightening—17 of the 19 policymakers forecast rates peaking above 5%.

While recent inflation readings have been encouraging, the Fed stressed that service prices remained a concern, driven by strong wage growth. Powell said that the US appeared to be experiencing a structural labor shortage, meaning that an increase in workers returning to the market was unlikely to bring wage growth lower. This view has been supported by the labor force participation rate in recent data, which declined for the third consecutive month in November. Average hourly earnings also rose 0.6% in November, following an upwardly revised 0.5% in October.

In our view, markets have moved too far, too fast to price an end to the rate hiking cycle. The S&P 500 is now around 12% up from its 2022 low struck in mid-October. We do not see this as fully reflecting the drag on growth imposed by prior tightening. In our view, this slowdown will take a toll on S&P 500 earnings, which we expect to contract by 4% in 2023. Bottom-up consensus earnings growth expectations are currently 5%, which may be too optimistic.

How do we invest?

While we do see inflection points for monetary policy and growth in 2023, the hawkish tone from the Fed underlines our view that the conditions are not yet in place for a sustained rally. We have preferred to hedge downside risk, rather than reducing our allocation to equities.

Against the backdrop of a slowing economy, we continue to favor a more defensive stance when adding exposure. In equities, we favor healthcare and consumer staples—sectors that are less vulnerable to the economic slowdown. 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. In fixed income, we see high grade and investment grade bonds as offering attractive yields with some protection against recession risks. We also recommend considering exposure to less correlated hedge fund strategies, including macro funds, which can be well-placed to navigate volatile markets.

Main contributors - Mark Haefele, Christopher Swann, Brian Rose, Vincent Heaney, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - Market reaction relatively muted after hawkish Fed, 15 December 2022.