Fed Chairman Jerome Powell delivered a tough, direct but hopeful message to the market and investors. However, the market reacted appropriately to the FOMC’s intentions to maintain tight financial conditions, allowing the Fed’s message to be heard loud and clear.
Terminal rate projections on Federal Funds Rates (FFR) have also moved to 5.1%, slightly higher than the previous 5%. As a result, 2-year bond yields (4.63%) crept closer to their October highs (4.64%) as the market adjusted to the Fed’s message of a higher-than-expected terminal rate. that I had previously expected.
The concomitant sell-off in markets yesterday (SPX: -2.5%, DJI: -1.55%, NDX: -3.39%) was appropriate to reflect the increased likelihood of a severe recession, given the Fed’s expectation of a higher terminal rate .
However, we believe that Powell performed admirably at yesterday’s press conference. He articulated that while the Fed would prefer to err on the side of caution (i.e., push too hard), Powell and his team could “use [their] instruments strongly to support the economy” if necessary.
Therefore, we posit that the Fed remains focused on combating inflation expeditiously as its first priority and is also concerned about triggering a severe recession (which we highlighted above as a critical risk) in the process.
As a result, we believe the risk-reward profile at current levels has likely mirrored our mild-to-moderate base recession scenario (articulated in a recent article).
We discuss critical levels for investors to watch, with the sharp pullback from yesterday’s sell-off offering brave investors another opportunity to add exposure.
Pivot? Not so soon, but that’s ok
We highlighted in our November 1 update to our members that “no Fed swing expected tomorrow”. We discussed why price action in bond yields showed that the market hadn’t anticipated a reversal from the Federal Reserve, even as markets rallied from their October lows.
Therefore, Powell’s comment that the Fed was not planning a dovish turn anytime soon did not surprise us. However, that was not a deal breaker for us because Powell behaved as the bond market had anticipated.
What is more important is where the FOMC sees the terminal rate moving forward. Therefore, Powell’s comment suggests that his terminal fee expectations should be revised higher, as tight labor market conditions remain a critical concern.
However, it did leave some hope that we could be near the end of his record-breaking walk cadence, with possibly two more walks to come. So the Fed’s message indicates that it potentially sees another hike in early 2023 after the next one in December, before the Fed goes into “data dependency mode.”
It is still too early to suggest whether the December hike would be 50bps or 75bps before the release of Printout of the CPI for October on November 10. However, we think this could be another potential opportunity for market volatility as the current consensus of 8.1% YoY growth could be too optimistic.
Current Cleveland Fed forecasts suggest an 8.2% print, in line with September’s 8.2% growth. In addition, core inflation (6.64%) is also projected to be higher than September’s 6.6% growth. So it’s pretty straightforward to understand why Powell needs to get this right to spray cold water on the bulls before they get too excited, like in August.
However, that also means that the pullback ahead of the CPI release could help de-risk entry levels further and position markets appropriately for negative surprises.
Market risk-reward ratio still points up from here
Analyst estimates for the S&P 500 have continued to fall further through October. As a result, the NTM P/E rose to 16.7x at the end of last week, given the rebound from its October lows.
This week’s sell-off has moderated SPX’s NTM P/E back to 16.1x, ahead of its October lows of roughly 15x (with higher earnings estimates at the time). However, as the Fed remains hawkish, we urge investors to consider adding more positions below 15-16x earnings to de-risk their entry levels.
In addition, the Fed is expected to maintain higher rates for an extended period until inflation decisively normalizes. So buying on pullbacks (where you get a lower P/E) is more appropriate than chasing surges.
Investors hoping for a quick return to the August highs could be sorely disappointed. Equity risk premiums have risen sharply. Coupled with the Fed’s aggressive stance, we posited that the market would not likely re-rate the SPX to August levels anytime soon as earnings estimates could fall further.
Third-quarter earnings for S&P 500 companies (excluding energy) have shown that profits have continued to fall on a year-over-year basis for the second consecutive quarter, with 3Q earnings (without energy) down 5.1%. Therefore, we expect analysts to continue revising their forecasts downward to reflect the increasing risks of a severe recession.
As such, August levels implying an 18.5x NTM P/E for the S&P 500 are not likely until we see a decisive turn lower in bond yields. For now, we have yet to reap such a move, with momentum still firmly in the clutches of bond sellers. While we think a mean reversion move is likely given the massive beating in bond markets, it is premature to call for one given the price action seen.
As such, investors should be more cautious with market analysis and consider adding more positions below a 15-16x forward P/E.
Consequently, we view the current pullback as constructive and see a reduction in entry risks, favoring a better risk-reward ratio for investors who did not chase the recent rally.