The S&P 500 is trading at 18.1x 12-month forward earnings, a 16% premium to its 15-year average. (ddp)

Prior to the strong nonfarm payrolls report for January, the federal funds futures market implied a peak rate of 4.81%. This has now risen to 5.19%, compared with the most recent median estimate from top Fed officials of 5.125%.

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 January 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 Chair Jerome Powell said 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.”

The 10-year US Treasury yield rose 20bps last week, while the S&P 500 fell 1.1% and the Nasdaq declined 2.4%.

Recent developments underline our view that an inflection point in policy 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. We expect both to continue to ease as the comparison with last year’s rebound in economic activity is removed from the calculation, though the CPI data for January, due this week, may how an increase in the headline month-over-month rate amid higher gas prices. 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 the US unemployment rate 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 Platforms along with a strong performance from less cyclical industries, notably healthcare and consumer staples. But the 425bps of Fed rate hikes last year, the fastest pace in decades, is feeding through to the economy and corporate earnings. Aggregate earnings are missing forecasts by 0.5 percentage points, and earnings per share are on track to decline by around 5%. 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.

The US equity market looks unlikely to lead the global pivot in sentiment. Valuations appear full. 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 equity market in the near term. We prefer emerging markets including China, as well as German equities, which we expect to be among the main early beneficiaries of China’s reopening and an inflection point in global growth in 2023.

We also continue to like defensive areas of the equity market—such as the healthcare and consumer staples sectors—that should be relatively resilient as growth and earnings slow, as well as value stocks, which have historically outperformed growth stocks in a high-inflation environment.

For more, see the Weekly Global: US equity rally stalls as Fed stays the course, 13 February, 2023.