Investors Whiplashed on Fed Comments

It was a volatile start to May’s trading in which the overwhelming focus was on the Fed. On Wednesday, the Federal Reserve announced its largest increase in the Fed Fund’s target rate in over 20 years. The 50 bps hike had been entirely anticipated, as was the Fed’s announcement that it would reduce its bond holdings by $95 billion a month, but despite that fact the announcement was still met with bullishness. This bullishness accelerated once Federal Reserve Chairman Jerome Powell commented during his post-meeting interview that a 75-bps hike was not “actively” under consideration by the FOMC.  With a large hike off the table for June, investors celebrated by driving the Dow Jones Industrial Average up 932 points in the final hours of trading on Wednesday. Unfortunately, the rally fizzled on Thursday once investors had time to really assess what had been said. While a 75 bps hike may not be actively on the table, the Fed did not waiver in its commitment to combat inflation with higher rates, and with the goal of a 3.0-3.5% Fed’s funds rate, there are still a significant number of hikes ahead. Markets woke up to this reality on Thursday, sending the Dow down 1,120 points. Growth-oriented shares in particular took the brunt, with the Nasdaq declining -5.20% on Thursday alone. Meanwhile, bonds markets also suffered as the yield on the 10-year treasury hit a four-year high of 3.146% on Friday. Payroll and manufacturing data took a backseat to the week’s monetary policy announcements, with traders largely reacting to the volatility and not fundamentals. Despite the high volatility, the Dow managed to finish the week essentially flat.

Fed Up with Inflation

After weeks of Fed officials conditioning markets to a larger than normal hike, the Federal Reserve pulled the trigger on Wednesday. The central bank announced it would raise interest rates by 50 bps. That’s the central bank’s biggest rate hike since 2000 in the final months of the Clinton administration. The move brings the benchmark rate to a range of 0.75% to 1.00%. More rate hikes are almost certainly on the horizon with 50 bps hikes potentially on the table for the next couple of meetings. The central bank also plans to begin unwinding its $9 trillion balance sheet in June. The plan will start with a monthly roll-off of $47.5 billion of treasuries and mortgage-backed securities for the first three months, which will ramp up to $95 billion in bond holdings per month. Despite recent calls by some Fed members for the central bank to get aggressive by using 75 bps hikes, Powell indicated hikes of that size were not actively on the table. At the same time, he still reiterated the central bank’s commitment to reigning in inflation, which was taken to mean that 50 bps hikes are potentially on deck at the Fed’s next several meetings. Markets missed the latter remark altogether, which made Wednesday’s bullish reaction (and Thursday’s subsequent correction) perplexing. Odds makers have placed a 78.6% chance of a 50 bps hike in June. That would bring the benchmark lending rate to 1.50%-1.75%. Furthermore, traders are putting an 80% chance for a 2.75%-3.25% benchmark lending rate by the Fed’s December meeting. The market rally and swoon made for good headlines, but nothing was learned this week that really justified the volatility.

Hiring Boom Continues to Boom

The popular explanation for the recent market volatility relies on the idea that we are headed for a recession. That is entirely plausible, but businesses don’t seem to think so. Workers remained in high demand as businesses added 428K workers to the payrolls in April. That beat estimates of 400K and matched March’s reading. The unemployment rate held steady at an extremely tight 3.60%. The leisure and hospitality sector led the gains with 78K added to the payrolls as businesses expect demand to be strong as the weather warms and the busy summer travel season ramps up. Despite the expected shift towards services, demand for goods is still expected to remain healthy. The manufacturing and transportation and warehousing sectors added 55K and 52K to the payrolls, respectively. Office workers and/or hybrid or remote roles these days also saw payroll gains with 76K hires during the month. It is a red-hot labor market, and businesses are having to increase wages to entice hires. Wages rose 0.30% in April, bringing the year-over-year rise in wages to 5.50%. The supply of workers, as measured by the labor force participation rate, fell -0.2 percentage points to 62.2. That was the first monthly decline since March 2021, but it also suggests that workers are confident in their situation to the degree that they can afford to not work. The equity markets may be pessimistic lately, but the labor market signals that businesses and individuals are still preparing for growth.

Strong Demand Lifts U.S. Businesses

Despite high inflation, supply chain disruptions, the war in Ukraine and a shortage of workers, strong demand for inventory re-stocking helped keep the manufacturing and services sectors in expansion. In April, the ISM Manufacturing Index hit 55.4. Levels above 50 indicate expansion in the sector, while levels below indicate contraction. Employment proved to be the biggest drag on the composite index, dropping -5.4 points to 50.9. Manufacturers are struggling to hire and retain qualified workers, which is starting to weaken the overall outlook slightly. Meanwhile, the ISM Services index hit 57.1, down slightly from March’s 58.3 reading. As was seen in manufacturing, service-oriented businesses are also having trouble adding and retaining workers as evidenced by the survey’s employment gauge falling to 49.5 from 54 in April. To punctuate the tight labor supply further, the Labor Department’s Jobs Opening and Labor Turnover Survey (JOLTS) report showed a total of 4.54 million resignations during the month, a new record. The imbalance continues to provide worker flexibility, making it easy for them to quickly jump ship for a better offer, but at the same time wages continue to lag inflation. Businesses are increasingly pointing to the tight labor market as a significant impediment to growth with supply chain disruptions continuing to be a problem as well. While Chinese lockdowns are likely to ease somewhat over the coming weeks, the summer is a critical stocking period for the holiday shopping season. To the degree that either the lockdowns continue into summer, or competition for goods increases once the Chinese consumer emerges from the lockdowns, it looks like retailers are going to have a challenging time stocking their shelves.

Covid-Zero Slams Chinese Manufacturing and Services Activity

Covid lockdowns continued to chip away at the Chinese manufacturing and services sectors in April. The Official Manufacturing PMI dropped to 47.4, down from the previous month’s 49.5. April was the second straight month of contraction. A private survey which measures activity at small/medium sized firms showed a similar contraction in factory activity. The Caixin/Markit Manufacturing PMI hit 46 during the month, down from March’s 48.1 reading. Meanwhile, the bottom fell out of the services sector with the Caixin Service PMI plummeting to 36.2 in April as China forced consumers far and wide into lockdown to contain the country’s recent outbreak. China’s self-imposed, zero-Covid policy, which has halted industrial production and disrupted supply chains was the main driver of slowing manufacturing and services activity. Despite the economic hit, China does not appear to be moving away from its zero-Covid strategy. More regions this week saw tighter restrictions, including the city of Zhengzhou which ordered residents to work from home and for schools to move online. The strict restrictions have made it difficult for businesses to operate in China, pushing sentiment to its lowest level since the initial shock of the pandemic in February 2020, and there is little visibility into when normal business operations may resume.

Final Thoughts

Watching the market rally on Wednesday, one of two things had to be true – either investors had collectively decided to suspended reality or the rally was going to be short lived. Thursday’s swoon was not so much a panicked sell-off as it was just a correction to an initial misperception of what the Fed had said on Wednesday. Sure, Powell taking a 75 bps hike off the table may have justified some relief, but investors managed to miss the bigger picture entirely. While a 75 bps hike may be off the table, a series of 50 bps hikes is still very much on the table. That is likely to take us 2.0-2.5% higher on the Fed funds rate from here. There was no new news in the Fed’s announcement this week and our throwing cold water on Wednesday’s rally is not us being bearish. We’re being opportunistic. The decline we’ve had year to date is finally getting to the point where values in financial services, big tech, consumer cyclicals and foreign developed stocks are starting to look attractive. Given that markets have historically front loaded their reaction during tightening cycles, and our belief that supply side factors are likely to begin relieving inflationary pressures by 2023, the window for a good old-fashioned capitulation moment is narrowing. That window closed just before it opened in mid-March, as the initial shock of Russian/Ukrainian War wore off and the Fed’s 50 bps hike messaging settled in, and on Wednesday it looked for a moment as if the same might be happening again, with investors having adopted a new dovish, Fed narrative. Fortunately, reality set back in Thursday and Friday and markets ended little changed on the week.