BY: JIM PICERNO
DIRECTOR OF ANALYTICS, THE MILWAUKEE COMPANY
Selling dominated global markets in the final month of the third quarter. All four of the major asset-class categories – stocks, bonds, securitized real estate and commodities – posted sharp declines in September, echoing similar results in August.
Reviewing performances through a trailing one-year lens shows commodities as an upside outlier. S&P GSCI, a broad measure of raw materials prices, rose 9.0% through September’s close vs. the year-earlier level. Otherwise, stocks, bonds and real estate are underwater over the past year.
The combination of ongoing interest-rate hikes by the Federal Reserve and slowing economic growth are the main headwinds for markets. It doesn’t help that the Ukraine war drags on, creating a toxic mix of humanitarian and economic challenges.
Analysts are debating if a recession is brewing for the U.S. in the months ahead. Even if output manages to stay positive, forecasts from various sources warn that growth will be modest at best. In turn, markets continue to price in elevated odds of softer growth, or worse.
Although a recession doesn’t appear imminent, the macro trend suggests the economy may contract at some point in the near term. The New York Federal Reserve’s Weekly Economic Index (WEI) reflects an ongoing slide in economic activity through late-September. Extending the downward drift through the end of the year into early 2023 suggests that recession risk could soon reach a tipping point.
Hawkish Fed remains a key risk
A key challenge ahead is the expectation that the Fed will continue to tighten monetary policy even as the economy slows. The catalyst: inflation remains high. The central bank’s preferred measure of pricing pressure – the core reading of the personal consumption expenditures price index – was stronger than expected in August. On a year-over-year basis, this inflation measure rose 4.9%, up from 4.7% in July – readings that remain far above the Fed’s 2% inflation target.
Not surprisingly, Fed funds futures are pricing in high odds for another rate hike at the next policy meeting on November 2. At October’s start, traders assigned a virtual certainty for a 50- or 75-basis-point hike, according to CME data.
Fed officials aren’t trying to suggest otherwise. Atlanta Fed President Raphael Bostic, for example, a few days ago said the “lack of progress [on taming inflation] thus far has me thinking much more now that we have to get to a moderately restrictive stance.” He advised: “For me, that is in the 4.25% to 4.5% range for our policy. My preference is that we get there by year end.” The current Fed funds target rate is a 3.0%-to-3.25% range.
The U.S. Treasuries market seems to agree that a hawkish policy path still lies ahead. The benchmark 10-year Treasury yield closed out September with a ninth-straight weekly increase, lifting the rate to 3.83%, or more than double the level when the trading year began.
Discounting the credibility factor
The critical issue for the Fed is that it’s still struggling to regain credibility after keeping policy too loose for too long and letting inflation develop a tailwind. In an effort to regain control, the central bank is now rushing to correct past mistakes, arguably at the risk of another policy error: going too far.
Fed Chairman Jerome Powell said as much at last month’s policy meeting, when he advised that the price for getting inflation under control may be a recession. “No one knows whether this process will lead to a recession or if so, how significant that recession would be,” he told reporters. “The chances of a soft landing are likely to diminish to the extent that policy needs to be more restrictive, or restrictive for longer. Nonetheless, we’re committed to getting inflation back down to 2%.”
The stock market is certainly discounting Fed rate hikes in the usual way: cutting prices. This year’s correction has made a dent in lofty valuations too. The Cyclically Adjusted Price Earnings Ratio (CAPE Ratio), which reflects the average of inflation-adjusted earnings over the past ten years, has fallen sharply in recent months to 27 from more than 38 at the end of 2021.
For investors looking for reasonable valuations, the drop reflects a substantial round of progress. Nonetheless, the market still doesn’t look inexpensive, at least by historical standards. But better days may be coming as the outlook for expected returns looks set to rise in the months ahead through the usual mechanism: falling prices.