The Federal Reserve’s latest meeting provided the clearest indications yet that policymakers see an end in sight to rate hikes. After 10 consecutive hikes and 500 basis points of tightening, the Fed dropped language in its statement that “some additional policy firming maybe appropriate.” Chair Jerome Powell confirmed in his post-meeting conference that, following the latest 25-basis-point hike, policymakers would now decide whether to hike rates further on a meeting-by-meeting basis.
But despite this positive indication, we believe equity markets have moved too far in pricing a more dovish rate trajectory, including the pace of cuts.
The latest labor market data looks too hot to justify a further dovish shift in Fed policy. Officials at the May FOMC meeting indicated that rate rises going forward would be data-dependent, with the employment figures a key variable. We believe several elements of the April employment data are likely to concern policymakers. The jobless rate moved back down from 3.5% in March to 3.4% in April, matching a 69-year low. Wage growth accelerated to 0.48% month-over-month, the highest since March 2022. And while employment growth was revised down for the prior two months, it surprised to the upside for the thirteenth month in a row, rising 253,000 in April. This is well in excess of the growth rate of the working age population.
Inflation, though moderating, remains too high for comfort. A key data point for the coming week will be the release of the April US Consumer Price Index. On a month-over-month rate, core inflation, which excludes food and energy, is expected to remain unchanged at 0.4%. Data along these lines is unlikely to convince the Fed that inflation is falling quickly enough to start contemplating rate cuts any time soon. In the other direction, we believe the Senior Loan Officer Opinion Survey is almost certain to show that large numbers of banks are tightening their lending standards, making it more difficult for the Fed to hike rates further.
Valuations in the equity market are pricing in too rosy an outcome for the economy. The S&P 500 is trading at roughly 18.8 times forward earnings over the coming 12 months, a 16% premium to the 10-year average. Historically, when the S&P 500 has traded above 18x, consensus earnings growth expectations are robust (14% on average) or the 10-year Treasury yield is less than 2%. At present, we expect S&P 500 earnings to contract 5% in 2023, and the 10-year Treasury yield is 3.44%. As a result, we believe US equities are pricing a high probability of a near-perfect outcome for the US economy. Yet tighter financial conditions, declining corporate earnings, and relatively high valuations all present risks.
So, we are least preferred on equities overall, and see greater upside in fixed income, especially high-quality government bonds where there is scope for capital gains in the event of an economic downturn. Given elevated valuations, we also recommend investors diversify beyond the US market and growth sectors.
Main contributors - Mark Haefele, Christopher Swann, Brian Rose, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Jobs data suggest markets too upbeat on Fed pivot, 5 May 2023.