As recently as last Wednesday, the federal funds futures market implied a peak rate of 4.81%. This has now risen to 5.15%, in line with the most recent median estimate of 5.125% from top Fed officials.
But Fed officials, too, have been hinting that a higher end point for interest rates may be necessary given the recent robust jobs data, which showed the unemployment rate falling to a 53-year low in January. Minneapolis Fed President Neel Kashkari said the labor market data “surprised all of us.” Atlanta Fed President Raphael Bostic said the central bank may need to consider a rate hike of 50 basis points at the next meeting, reversing course after slowing the pace of rate rises to 25bps. Fed chief Jerome Powell said on Tuesday that the payroll data underlined his view that Fed officials have a “significant road ahead” to cool inflation, adding they did not expect the jobs data “to be this strong.”
Recent developments underline our view that an inflection point in rates, growth, and market sentiment has not yet been reached.
The labor market needs to cool for the Fed to hit its inflation target. Both of the main metrics of inflation—the consumer price index (CPI) and the personal consumption expenditures (PCE) index—have indicated that price pressures have been moderating in recent months. We expect both to continue to ease as the comparison with last year’s rebound in economic activity is removed from the calculation. Interest-rate-sensitive parts of the economy, especially housing, are also slowing. However, a sustained return to the Fed’s target of 2% inflation will not be possible without a moderation of pay settlements. With unemployment at 3.4%, the lowest level since 1969, this looks hard to achieve.
The lagged effect of prior rate hikes will continue to slow earnings. The US fourth-quarter earnings season has delivered a few pieces of positive news, including an upbeat report from social media company Meta along with a strong performance from less cyclical industries, notably healthcare and consumer staples. But the 425bps of Fed rate hikes from 2022, the fastest pace in decades, is feeding through to the economy and corporate earnings. Aggregate earnings are missing forecasts by close to 1 percentage point, and earnings per share are on track to decline by 3.4%. This underlines our view that an earnings recession is coming, especially with mounting macroeconomic headwinds. The tech sector results underlined that even high-growth areas, such as cloud services, have been slowed by reduced business spending. Pressures on consumer spending also appear to be impacting the sector, as we forecast.
The US equity market looks unlikely to lead the global pivot in sentiment. Valuations appear full, in our view. The S&P 500 is trading at 18.1x 12-month forward earnings, a 16% premium to its 15-year average. We could justify this somewhat elevated multiple if earnings were below trend (they are more than 10% above trend), if earnings growth looked poised to accelerate rapidly, or if interest rates were at rock-bottom levels like they were in 2020 21. None of those conditions appear to exist today.
So, we continue to see headwinds for the broad US market in the near term. We expect the Chinese and German equity markets to be early beneficiaries from an inflection in market sentiment later this year.
Main contributors - Mark Haefele, Brian Rose, Christopher Swann, Alison Parums, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Jobs data calls dovish US pivot into question, 8 February 2023.