Market Strategy 9/19/2022
It Don’t Come Easy
Investors’ patience can be put to the test over the course of a Fed hike cycle
Key Takeaways
- All eyes this week will be focused on the outcome of the Fed’s FOMC rate decision on Wednesday. Expectations are for a 75-basis point hike in light of last week’s uptick in the core CPI.
- Last week’s drama within the stateside equity markets should serve to remind investors that increased volatility is not beyond the norm in the early stages of a Federal Reserve hike cycle.
- A look under the hood of last week’s market decline pointed to the symmetry of the selling across the major indexes suggesting algorithmic trading which may have led to stocks being oversold, similar to what occurred in June, near the start of the summer rally.
- Last week’s economic data showed consumers becoming more optimistic on the longer-term outlook while curbing their inflation expectations. Retail sales in August were also stronger than expected.
Last week’s stateside equity market declines on a hotter than expected Core CPI number should remind investors that it’s never easy when stocks have to “run the gauntlet” of a Fed Funds hike cycle, particularly in the earlier part of the cycle—and even more so if the Fed is considered to be “behind the curve” or “late to the party in removing the punch bowl of liquidity” to get down to the business of putting untoward levels of inflation in check. With it still too early in the current Fed tightening cycle to have effect and with just four hikes (0.25%, 0.50%, 0.75% and 0.75% respectively in April, May, June and July) under its belt the disappointment felt by the market and the subsequent thrashing given to stocks should come as no surprise.
The headline CPI (Consumer Price Index) number which came in at 8.3% year over year was slightly hotter than expected but lower than the prior month’s number. However, the Core CPI number (ex-food and energy) up 6.3% (from July when it was up 5.9%) was what rattled the market last Tuesday and began stocks’ trek lower in three of last week’s five trading sessions. The decline in oil (aka energy) which is excluded from the core CPI after all was an old story (with gasoline prices off some 26.7% from their peak in June) for traders going into last Tuesday.
It was the “heat” evident in persistent inflation generated by other price index components that evaporated positive sentiment for the balance of the week that helped push stocks lower. Among those hot points were prices for rents and the strength in the jobs market that came with higher wages. These hot points were enough to raise concern about the effectiveness thus far of the Fed’s efforts to curb inflation and send stocks lower.
By the end of the week the Dow Jones Industrial Average, S&P 500, the S&P 400 (mid caps), the S&P 600 (small caps), the Russell 2000 (small caps) and the NASDAQ Composite (some 40% weighted in tech and tech related companies) were respectively off on the week: 4.13%, 4.77%, 4.71%, 4.08% and 5.48%. The relative symmetry of the losses suggests algorithmic selling at work as selling begat selling in three of last week’s stateside trading sessions.
We should note that the market appears to be oversold as the forward multiple of the S&P 500 is now back near to where it was before the market hit its low on June 16, prior to its summer rally. We would also note that the 10-year Treasury note yield is also just under its high of 3.48% reached on June 14.
Taken in context of the degree of the Federal Reserve Board’s pivot at the end of last year, their efforts taken since (as well as all the communication in Fed Speak by the Chairman and other Fed officials over the course of this year) and with consideration of historical context of past Fed tightening periods—we are of the view that the equity market’s reaction to the higher than expected core inflation number last week was pretty normal (see page 12 for our Maximum S&P 500 Drawdowns 1971-1989).
We think it’s important to recall that the Fed’s current battle with inflation is likely not quite as daunting a consideration as was that of Paul Volcker’s in 1978 when as chairman of the Fed he faced bringing inflation in check that he’d inherited from a prior Fed Chair who had failed to act in a timely manner and inadvertently let inflation become deeply embedded in the US economy over a period of 10 or 15 years.
In this cycle the Fed and its critics had begun dialogue on inflation early in the game and as recent as last year. In the period of the most recent hike cycle, which occurred from December 2015 through December 2018, dialog between the Fed and market participants was extremely active as well. And therefore the economy and the markets were able to manage expectations of the course of that cycle.
Looking forward in our view the Fed in this cycle should remain vigilant and active in working to curb inflation with rate hikes likely to continue through at least the first quarter of next year.
Drawing on our experience working in the markets through periods of Fed tightening over the course of nearly forty years we’d expect the markets sooner than later to recognize that the end of “free money” (untenably low interest rates) is not a bad thing and soon after that they’ll likely get a sense that the Fed won’t raise rates “forever” but just as long as it takes to curb the inflation that came from overstimulation of the economy over the course of the pandemic by both the Federal Reserve and politicians in Washington.
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