The S&P 500 fell 2.5% on Wednesday after Federal Reserve Chair Jerome Powell indicated that it was “very premature” to think about pausing rate hikes. His comments came after the US central bank raised benchmark rates by 75 basis points for the fourth consecutive meeting, setting the federal funds target range between 3.75% and 4%.
Powell warned that the Fed still had “some ways to go” in its efforts to tame inflation, adding that data since the last policy meeting in September “suggests that the ultimate level of interest rates will be higher than expected.” At that last meeting, the median expectation of Fed policymakers was for a peak in rates of 4.6%. Markets are now priced for rates to peak around June next year at over 5%.
The chair’s comments caused a swift reversal in equity markets, which had initially responded positively to indications in the Fed statement that the pace of rate rises could slow. The statement indicated that the Fed would “take into account the cumulative tightening” implemented so far as well as the “lags with which monetary policy affects economic activity and inflation.” Powell confirmed that a more gradual pace of tightening was coming, possibly as soon as the December meeting “or the one after that.”
The Fed meeting came a day after data added to evidence that the labor market remains tight. Job openings rose 437,000 in September to 10.72 million, according to the JOLTS data, reversing August’s decline and coming in well above consensus expectations for a fall to 9.75 million. As a result, there were 1.9 unfilled jobs for every unemployed worker in the US at the end of September, suggesting that wage growth could remain elevated.
What do we expect?
The Fed’s decision and latest guidance are consistent with our recent view that it is too early to position for a dovish pivot in monetary policy. Fed officials have been indicating that a such shift in would require consistent evidence that inflation pressures are abating and that the labor market is cooling. Neither of these conditions have so far been met. The core personal consumption expenditures deflator, excluding food and energy, accelerated to 0.5% month-over-month in September. On a year-over-year basis, the measure climbed to 5.1%, up from 4.9% in August. Meanwhile, the jobless rate for the month fell back to a 50-year low of 3.5%.
A deceleration in the pace of rate hikes from the recent 75-basis-point norm is possible. But this is likely to be contingent on cooler inflation and jobs data in the run up to the 14 December meeting. In addition, markets are rightly more concerned with the ultimate level of rates rather than the pace of tightening. Overall, we do not believe the conditions are in place for a sustained equity market rally. The Fed, along with other major central banks, looks likely to keep tightening rates until the first quarter of 2023; economic growth will likely continue to slow into the start of the new year; and global financial markets are vulnerable to stress while monetary policy continues to tighten. In addition, we believe such headwinds have yet to be fully reflected in earnings estimates or equity valuations. We now expect global earnings per share to fall by 3% in 2023, versus the bottom-up consensus for 5% growth.
How to invest?
We have urged investors to be cautious regarding the recent rally, which had taken the S&P 500 up 9% from its low point in mid-October. But given the potential for periodic bounces, we have favored strategies that add downside protection while retaining upside exposure.
In our view, the risk-reward for markets over the next three to six months is unfavorable, and today’s Fed statement supports that view. Against the current backdrop, we recommend:
Focus on defensive assets when adding exposure. Within equities, we like capital protected strategies, value, and quality income. We like global healthcare, consumer staples, and energy, and have a least preferred stance on growth, industrials, and technology. Weak mega-cap tech earnings over the last week support our least preferred view on technology. By region, we like the cheaper and more value-oriented UK and Australian markets relative to US equities, which have a higher technology and growth exposure and where valuations are higher.
Within fixed income, we prefer high-quality and investment grade bonds relative to US high yield. And in currencies, we prefer the safe-haven US dollar and Swiss franc relative to the British pound and euro. Click here for more.
Seek uncorrelated hedge fund strategies. Hedge funds have been a rare bright spot for investors in 2022, with some strategies, like macro, doing particularly well. With inflation data and central bank policy likely to continue driving a high correlation between equities and bonds in the near term, we recommend investors diversify into less correlated hedge fund strategies to navigate market uncertainty. Click here for more.
Find value in private markets. Some private market funds are likely to revise down net asset value estimates as a result of the public market contraction this year. But putting fresh capital to work in private markets following declines in public market valuations has historically been a rewarding strategy. In the current environment, we favor value-oriented strategies to build up private market exposure. Click here for more detail.