Market’s Multi-Week Rally Fizzles When Faced with the Hard Truth
November 4th, 2022
The market had an uphill challenge coming into the week, having both the Fed and jobs announcements stacked against it. That didn’t stop bulls, however, from trying to keep the momentum going, despite the week’s major data releases being less than supportive of their case. On Wednesday, the Fed raised rates by 0.75% for the fourth time this year. The bank also provided revised language summarizing its members current perspective on the economy. Markets initially cheered the announcement, interpreting it as dovish until Chairman Jay Powell took to the stage and stomped on that dove’s throat during his post-FOMC meeting conference. His message? The Fed’s job is nowhere near complete, sending markets into a tailspin on Wednesday. Similarly on Friday, stocks surged coming out of the gate over news the unemployment rate had ticked slightly higher. That faded by mid-morning as the reality set in that hiring and wage figures still remain very strong, and with its implications for the CPI on the horizon, bulls had to accept defeat for a winning week. Rounding out the economic headlines were the ISM Manufacturing and Services reports that showed slowing in October for both sectors. By the closing bell, the S&P 500 had shed -3.57% on the week.
We Still Have a Ways to Go
The Federal Reserve hiked interest rates by 75 bps on Wednesday to bring the benchmark lending range to 3.75% to 4.00%. This is the first time in history that the Fed has raised rates so aggressively by utilizing four consecutive, 0.75% hikes, bringing the Fed’s overall target rate to the highest it has been since 2008. The announcement came with two notable, and somewhat conflicting alterations in the Fed’s written guidance. The first was that the Fed would consider the “cumulative” impact of previous hikes as it thinks about the Fed’s future rate path. This was the dovish language that markets initially seized upon and which was interpreted as acknowledging the lag effect still expected from the Fed’s previous actions and as providing daylight to a future pivot. Indeed, Powell himself indicated the Fed could revert to a 50 bps hike in December or January. Unfortunately, markets failed to acknowledge the stronger operative language, that Powell hammered on in his post conference interview, where he said the Fed “anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” In other words, even if the Fed transitions to a slower pace and magnitude of hikes, the terminal level of rates is going higher and will likely be sustained for longer. Stocks retreated sharply on a more hawkish post-FOMC conference with traders raising their estimates on the terminal rate (peak interest rate) to 5.00%, up from the Fed’s current forecast of 4.60%.
Signs of Peak Employment Emerge
If the post-conference interview was a body blow for investors, that was followed by a stiff jab from the jobs report on Friday. For the Fed, the jobs market and inflation are intertwined, the former of which remains the thorn in its side by keeping individual’s propensity to spend high. Although signs are beginning to emerge of peak employment indicators, the labor market still remains relatively tight with healthy wage growth even as the Fed has sharply lifted rates. In discussing recent labor data, Powell noted that despite the strong jobs market a classic wage-price spiral has yet to emerge. Yet, he reiterated the need to fight against that before it happens.
The October nonfarm payrolls report provided fodder to that position by notching another strong print, adding 261K new hires. That bested Dow Jones estimates of 205K. Gains were broad-based with healthcare, professional and business services, and leisure and hospitality leading the gains. The market’s initial enthusiasm over the report was not related to the payroll gains but rather the deceleration in wage growth and overall hiring that some believe are signs cracks may be emerging. The unemployment rate rose to 3.70%, up from September’s 3.50% as the labor force participation rate held steady. Wages also showed signs of easing, up 4.70% from a year ago. That’s down from September’s 5.20% yoy rise and this year’s peak of 5.60% in March. While these figures indicate some fundamental weakening, companies on the whole have been reluctant to implement large layoffs. In the past week, jobless claims dipped slightly to 217K, down from the previous week’s 218K. Over the past month they have averaged around 219K per week, which is still low historically. All this to say, that while a softer labor market would surely be welcomed by the Fed, that has not taken hold quite yet.
Higher Inflation and Rates Reduce Spending
Higher prices and higher interest rates hit both the service and manufacturing sectors in October. The ISM Services Index dipped to 54.4 in October from 56.7 in September. Numbers above 50 indicate expansion while numbers below indicate contraction. The decline in output was driven by a drop in business activity, new orders, and employment. The drop in employment was noteworthy, falling to 49.1 from 53 the previous month as some companies found it challenging to find qualified workers while others pulled back on filling open positions due to uncertain economic conditions. The services report also showed prices rising, up 2 percentage points in October to send the prices gauge to 70.7 on renewed supply chain concerns. The upturn in prices comes after five straight months of declines. Factory floors also slowed in October with the ISM Manufacturing Index barely staying in expansion territory at 50.2 in October. That was down from September’s 50.9 reading. The decline was driven by new orders remaining in contraction with the new orders gauge reading coming in at 47.1. However, there may be some price relief for consumers as the price index fell 5.1 points to 46.6. That was the lowest reading since the pandemic and suggests power is shifting back to the buyer. With the Federal Reserve poised to continue to hike rates to combat inflation, recession jitters are expected to remain high in the months ahead.
We have two thoughts this week – neither of which are earth-shattering, but they are worth noting. The first is that the market is spring loaded for a Fed pivot. With each Fed announcement or indicator related to inflation, there is an inclination by investors to bid up the market by first seeing the silver lining before taking a step back and putting the news in the context of the Fed’s bigger narrative. This happened this week with both the early interpretation of the Fed’s statement and again with this week’s jobs report. Paraphrasing an economist from Nomura, who was interviewed by The Wall Street Journal, he attributed the market’s reaction akin to cheering a decelerating from 100 MPH to 85 MPH before being reminded that the Fed’s speed limit is only 40 MPH. The market’s reaction is almost comical, but it should give longer term investors comfort knowing that the market really does want to go up once the Fed’s work is done once and for all. The second observation is that the major indices don’t tell the full picture of the economy or the market performance of the average company. There have been two dynamics in play this year related to monetary policy. The first has been a recessionary and risk-off dynamic. When this dynamic has been in play basically the whole market was selling off. Growth led the way down, but value and small caps were not far behind. It is a pretty simple mindset: rates up, recession risk up, money flows out across the board. This dynamic has started to give way to a newer, although not entirely new, dynamic that accepts rates “higher for longer”. In this environment, present values matter more–not the future value world we have been living in where future profits are discounted by zero percent. Cash flow, pricing power, financial agility matter more in this new environment and asset classes and companies that possess inflationary hedges in their operations tend to do better. With the economy still holding up reasonably well, and the Fed committed to a sustained tightening campaign, it explains why you are seeing companies like those in the Dow Jones Industrial Average and Russell 2000 (on average) far outperform those in the S&P and NASDAQ (tech, growth companies). Over the last month, the DJIA and Russell 2000 are up 9.1% and 4.63% respectively versus the S&P 500 at +1.84% and NASDAQ at -4.16%. The point is that while the interest rate debate is creating volatility and while the debate is not going away anytime soon, there is a paradigm shift taking place which means it is not all bad news for all companies across the board.
The Week Ahead
With consumers back to their pre-pandemic fall routines, investors are looking for inflation to further ease as consumers have less time on their hands for spending on experiences or goods. However, broad-based inflation is expected to keep prices elevated. Economists are estimating consumer prices to rise 8.10% yoy in October, relatively in line with September’s 8.10% increase. Core inflation, which excludes volatile food and energy, is forecasted to increase 6.58%, matching September’s annualized rise. Aside from October’s inflation report, it will be a relatively quiet week for economic data as voters head to the polls for midterm elections. It’s a tight race as Democrats attempt to hold off Republicans for control of Congress. The latest polls suggest Republicans are poised to take control of at least one chamber if not both. If the polls prove right, will an elephant in the room be good for business or lead to more political gridlock? We’ll have the rundown on how markets have performed in past midterm election cycles.
It’s that Time of Year Again: Daylight Saving Time Ends Sunday, November 6th
This Sunday marks the end of Daylight Saving Time (DST). The good news is that if you live in a state that observes these twice-yearly time changes, you will get back the hour of sleep you lost in March when DST started. The U.S. Senate unanimously passed a bill earlier this year called the Sunshine Protection Act to put an end to the twice-annual changing of the clocks. The legislation still needs to make its way through the House of Representatives before it can be signed into law by President Biden.
When DST ends and the clocks shift back this Sunday at 2:00am it will get lighter earlier in the mornings, and sunset will be an hour earlier as well from November to March. If the Senate bill is signed into law, clocks would be set ahead in March 2023 and then kept there permanently, so instead of DST for eight months of the year, we would have DST for all 12 months. A year-round DST means the sun would rise and set an hour later than we’re used to from November to March, so we would have darker mornings and longer daylight in the evenings.
Daylight saving started as a measure to reduce energy consumption. Benjamin Franklin is sometimes credited with conceiving the idea of daylight saving in 1784 to conserve candles, but the U.S. did not institute it until World War I. Since then, the observance of DST has been inconsistent with a hodgepodge of time observances and with the U.S. passing several pieces of legislation from the 1940s to the 2000s to achieve a uniform time standard. Studies have shown the energy savings are miniscule: daylight time does reduce demand for household lighting, but some research has shown that it increases demand for cooling on summer evenings and heating in early spring and late fall mornings.
While the longer evening daylight hours may be enjoyable, some people might not see the sun until hours after they wake up, which means commuting to work or heading to school in darkness. Proponents of a permanent DST argue that this is beneficial for people to enjoy evening activities and for businesses such as restaurants, theaters, and retail. However, some cities would have really late sunrises with a permanent DST, particularly those cities located on the western edge of their time zone.
For instance, with the law currently in place, the sun is scheduled to rise in New York at 7:16 a.m. on Dec. 21, the shortest day of the year known as the winter solstice. But if the Sunshine Protection Act takes effect, residents in the Empire State would have to wait until 8:16 a.m. to see the sun rise. With DST, the sun will set in New York at 4:31 p.m. the day of the winter solstice, but with the Sunshine Protection Act, that would be pushed to 5:31 p.m.
The U.S. isn’t the only country grappling with this debate. Seventy other countries around the world change their clocks, too, and Mexico’s Senate just voted on October 27, 2022 to end daylight saving time for most of their country, but their bill still needs to be signed into law. This chaos of clocks is an example of history repeating itself. The U.S. attempted a permanent DST in January 1974 amid a national energy crisis. Year-round DST was supposed to last two years at the time, but public support fell once the reality of dark mornings set in, and Congress reversed course, ending the DST trial in October that same year.
While there is wide bipartisan support to stop the biannual changing of the clocks, the Sunshine Protection Act is stalled in the House due to other pressing legislation and disagreements over whether a permanent standard time or a permanent DST should be adopted. Time is running out for the bill to pass this year, but in the meantime we can all enjoy the longest Sunday of the year this weekend.