When Will the Fed Brake?
The inflation puzzle still seems far from being solved. The Federal Reserve is confronting mixed data showing price gains may be slowing, but average hourly earnings are still climbing in defiance of the central bank's many efforts to tamp down the economy. The market, meanwhile, appears to have a more optimistic view of the Fed's powers. Despite the central bank's consistent messaging that it plans to "hike and hold" throughout 2023, the futures market is pricing in rate cuts late in the year.
For their part, central banks abroad are slowing their rate hikes and international stock markets have responded positively. The MSCI Euro Index, which tracks the stock market performance of companies based in the eurozone, has delivered its best performance since the late 1990s so far this quarter.
U.S. stocks and economy: Fed in the middle
As we turn to 2023, the story for the U.S. economy will likely shift focus from inflationary concerns to potential stresses in the broader economy and labor market.
To be sure, inflation is still high in relative historical terms, even if rates are slowing. And wage growth is proving too stubborn for a Fed keen on holding down inflation expectations. Average hourly earnings grew 5.1% from a year earlier in November, according to the most recent jobs report, and the annualized gain over the prior three months (which is a better gauge of the near-term trend) was the fastest since January.
The Atlanta Federal Reserve bank's wage growth tracker corroborated the trend, showing headline growth of 6.4% in November, with both job switchers and job stayers seeing gains, as shown in the chart below.
Get paid to stay or go
Source: Charles Schwab, Bloomberg, as of 11/30/2022.
The Atlanta Fed Bank defines a "job stayer" as someone in the same occupation and industry as a year earlier, and with the same employer in each of the last three months. A "job switcher" includes everyone else (i.e., people in a different occupation or industry or employer).
The wage gains for job switchers are a worrying signal of how strong demand remains for labor. The Fed wants to create more labor market slack in the hope that it can crush job openings (demand) without causing lasting damage in the form of a high unemployment rate. We think that is a tough goal, mostly because of the lagging nature of the unemployment rate and also because of how aggressive this tightening cycle has been.
Then again, the Fed is likely still far from declaring victory on the inflation front. Stronger wage growth goes hand-in-hand with higher unit labor costs, which are in turn highly correlated with inflation. As you can see in the chart below, the two-year percentage change in unit labor costs rose to 11.2% in the third quarter, the fastest since the early 1980s. Such gains don't mean workers are getting more productive, either: Productivity's 1.4% drop was the worst since 1975.
Productivity sags as labor costs spike
Source: Charles Schwab, Bloomberg, as of 11/30/2022.
SentimenTrader's Smart Money Confidence and Dumb Money Confidence Indexes are used to see what the "good" market timers are doing with their money compared to what the "bad" market timers are doing and are presented on a scale of 0% to 100%. When the Smart Money Confidence Index is at 100%, it means that those most correct on market direction are 100% confident of a rising market. When it is at 0%, it means good market timers are 0% confident in a rally. The Dumb Money Confidence Index works in the opposite manner.
Unit labor costs and productivity are also both lagging measures, but higher-frequency data continue to underscore higher employment costs and weak productivity growth. As is the case with inflation at large, trends are moving in a favorable direction, but the pace of change is likely too slow for the Fed to take its foot off the brake.
With a hawkish Fed intending to keep rates higher for longer, the return of a higher risk-free rate has important implications for stock investors. Not only are stock fundamentals coming back into play courtesy of higher rates and economic weakness, but the market's leadership profile is decisively shifting. Gone are the days when the market's gains depended on the performance of just a handful of stocks (i.e., the "big five" or the "super seven"). As shown in the chart below, the equal-weighted S&P 500 Index has outperformed its market capitalization-weighted peer by its largest margin since 2010.
Source: Charles Schwab, Bloomberg, as of 12/9/2022.
The S&P 500® Equal Weight Index (EWI) is the equal-weight version of the widely used S&P 500. The index includes the same constituents as the capitalization-weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight—or 0.2% of the index total at each quarterly rebalance. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
This spread won't last forever, but it supports the notion that screening for companies with strong fundamentals (i.e., strong profit margins, low volatility, high free-cash flow) could continue to work in investors' favor. In the years leading up to the pandemic, investors were largely rewarded for taking a passive approach by focusing on capitalization-weighted strategies—due to the aforementioned outperformance of the few-but-mighty large-cap companies that dominated the S&P 500. However, with their performance lagging this year, the current bear market has rewarded stocks (smaller in market value) that serially underperformed at the expense of their larger peers. Thus, it has paid to look elsewhere, particularly for high-quality companies.
Fixed income: A widening gap
The Federal Reserve continues to hike short-term interest rates and signal that it plans to keep rates high throughout 2023, but financial markets aren't convinced. Despite consistent messaging from the Fed that it plans to "hike and hold" throughout 2023, the futures market is pricing in rate cuts late in the year.
The market is pricing in a steep rise in the federal funds rate
Market estimate of the federal funds rate using Fed Funds Futures Implied Rate (FFM2 COMB Comdty). As of 12/12/2022. For illustrative purposes only. Please read the Risk Disclosure for Futures and Options prior to trading futures products. Futures accounts are not protected by SIPC.
The diverging views about policy suggest that investors have more faith than the Fed itself in the Fed's ability to rein in inflation. The inverted yield curve and low readings for implied inflation expectations in the Treasury Inflation Protected Securities (TIPS) market suggest that investors anticipate slowing growth and easing price pressures in the first half of 2023.
Falling commodity prices, a weakening housing market, and a slowdown in manufacturing point to disinflationary forces already at work. But the prospects for future foreign demand are also weak, given how both developed and emerging-market countries have struggled with this year's spike in energy costs.
Global PMI tends to move in tandem with 10-year Treasury yields
Source: Bloomberg, S&P Global. JP Morgan Global Manufacturing PMI, Diffusion Index SA (MPMIGLMA Index), US Generic Govt 10 Year Yield (USGG10YR Index). Monthly data as of 11/30/2022.
Past performance is no guarantee of future results.
It's somewhat ironic that the Fed appears to be less confident than the market is about its ability to deliver lower inflation for longer. Having failed to anticipate inflation's persistence coming out of the pandemic, officials are wary of declaring victory too soon. Fed Chair Jerome Powell has talked about the Fed's mistake of easing policy too early in the 1970s, which led to a rebound that required very high interest rates and deep recessions to bring it under control. Officials also point to the current tightness in the labor market and rising wages along with readings on "sticky" inflation as reasons to keep rates higher for longer.
Average hourly earnings
Note: Pre-pandemic average 2.7% date range 10/31/2015-12/31/2019.
Source: Bloomberg, using monthly data as of 8/31/2022. US Average Hourly Earnings All Employees Total Private Yearly Percent Change SA (AHE YOY% Index).
Atlanta Fed Sticky Price Index
Source: Federal Reserve Bank of Atlanta. Atlanta Fed Core Sticky 12 CPI Month (SCPICS12 Index), Not Seasonally Adjustable (NSA), percent change YoY. Monthly data as of 10/31/2022.
Note: The sticky price index sorts the components of the consumer price index (CPI) into either flexible or sticky (slow to change) categories based on the frequency of their price adjustment.
Past cycles don't necessarily provide clear guidance around how long the federal funds rate could stay at its peak. The Fed has held it at the peak level for as little as three months, or as long as 18 months. Notably, cycles in the high-inflation era of the early 1980s tended to be shorter, although yields started at very high levels.
In past cycles, the Fed has lowered rates soon after hitting the peak
Source: Bloomberg. Federal Funds Target Rate - Upper Bound (FDTR Index). Daily data as of 12/12/2022.
Note: Data is the short-term interest rate targeted by the Federal Reserve's Federal Open Market Committee (FOMC) as part of its monetary policy. Past performance is no guarantee of future results.
In the end, the Fed alone decides how high to raise the federal funds rate and how long to keep it there. Consequently, there is risk that yields on bonds with maturities of one to three years may move up from current levels if the Fed keeps rates higher for longer. However, a tighter-for-longer policy in the face of slowing growth and easing inflation would likely mean an even greater inversion of the yield curve and lower long-term yields over time.
We suggest fixed income investors focus on the long-term outlook rather than trying to second-guess near-term Fed policy decisions. Current yields for high-quality bonds such as Treasuries and other government-backed bonds, investment grade corporate bonds and municipal bonds are the highest in several years. A laddered approach to investing in bonds can offer a way to invest for income without trying to time the market.
Global stocks and economy: Best quarter ever
The stock market has responded positively to signs central banks are slowing their rate hikes. The MSCI Euro Index, which tracks the stock market performance of companies based in the eurozone, has posted its best performance (quarter to date) since the eurozone began in the late 1990s.
Best quarter ever for eurozone stocks
Source: Charles Schwab, Bloomberg data as of 12/8/2022.
Performance for Q4 2022 covers 10/1/2022 through 12/8/2022. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
While a pivot to rate cuts does not seem likely in the near term, central banks seem to be signaling a step down in the size of rate hikes, and in some cases, even a pause.
- The U.S. Federal Reserve has slowed the pace of rate hikes from 75 basis points (bps) in November to 50 bps in December.
- That follows the Bank of Canada stepping down from 75 bps in late October to 50 bps in December and saying it would consider "whether the policy interest rate needs to rise further."
- The central banks of Australia and Norway stepped down from 50 bps to 25 bps at their meetings back in October/November and repeating 25 bp hikes in December.
- The central bank of one of the largest emerging-market economies, Brazil, along with the central bank for the largest emerging-market economy in Europe, Poland, both paused a few months ago, leaving rates unchanged at recent meetings.
As a possible counterweight to this trend of slowing hikes, China's reopening as it winds down zero-COVID protocols could increase inflation and lead to central bank rate hikes in 2023.
The shift from the aggressive pace of hikes that took place for much of 2022 took place at the start of the fourth quarter and aligned with the shift in market performance from the bear market that unfolded in the first three quarters of the year, giving us a fourth-quarter rally. Leading that rally has been international stocks. Since the start of the fourth quarter, the MSCI EAFE Index of international stocks climbed 20% by the start of December and is outperforming the S&P 500 on a year-to-date basis, despite this year's big gain in the U.S. dollar.
The outperformance by international stocks may continue in 2023. International stocks tend to possess more of the characteristics, like high dividend yields and lower price-to-cash-flow ratios, that have contributed to outperformance within and across sectors and countries this year. Earnings growth is also stronger outside the United States, and analysts expect it to remain so in 2023. The year-over-year growth earnings growth for S&P 500 companies in the recently reported third quarter was 4.1%, compared to 30.5% for companies in Europe's STOXX 600 Index. Combined with lower valuations, this has supported international stock outperformance, which may become more pronounced with a pause or reversal in the sharp rise of the dollar that characterized much of 2022.