Transcript
Amada Agati:
In this edition of "Adding Alpha," we quickly recap the November Fed meeting and make some assessments about what it means going forward.
Longer for longer appears to be the name of the game for the Fed's monetary policy strategy and the scheme of the market trying to call the Fed's bluff: More rate hikes, a higher terminal rate, and a longer overall tightening cycle.
During the meeting, the Fed raised rates by 75 basis points, which was in line with our expectations, to a new range of 3.75 to 4% --not overly restrictive territory just yet for markets, financial conditions, and the economy.
Since so much of the path forward has been and continues to be dependent on Fed rate hikes, the futures market still has the following path priced in: about 50 basis points for December, 25 basis points in February of 2023.
And the market, believe it or not, is now starting to price in another interest rate increase in March, taking the terminal rate to about 5%. All of that being said, the market is still pricing for about 25 basis points worth of cuts at some point in the second half of 2023.
But Powell basically told markets don't expect any rate cuts. It's premature and hasty to expect an abrupt policy pivot. It's another reminder the Fed and markets have not been on the same page at all this year, and also a not-so-friendly reminder that the Fed has a dual mandate, focused on the labor market and also price stability.
Supporting the stock market is definitely not one of them. As we've continued to say all year long, what matters most for markets is what happens to the expected terminal rate.
While the Fed didn't formally update its dot plot or the expected terminal rate during the November meeting, the messaging was clear that markets should expect a higher end state for monetary policy.
Anything above the current 4.6% is far into restrictive territory for markets, the economy, and financial conditions, which leads us to believe the odds of a hard landing are now higher than 50-50 at this point.
And while we haven't gotten close to an S&P 500 earnings recession yet --we're still looking at about 6% earnings growth for this year, followed by another 6% for 2023 -- we do think as financial conditions continue to tighten and growth slows even more that it's likely to occur in 2023.
As we've seen this earnings season, many of the perennial winners in software and even Internet services are showing that they're not quite as inflation resistant as the market expected.
So the path forward is really going to remain quite challenging if inflation stays elevated in a slowing economic growth backdrop. We've been saying all year that fair value for the S&P 500 is in a range of about 15 to 17 times of forward P/E.
We're trading at about 16.2 times or so today. Assuming we continue on a slowing but still positive growth path, a.k.a. that soft landing scenario, we are definitely not priced at recessionary valuation levels.
Based on what the Fed said, there's definitely more downside to come in terms of price returns and also valuation multiple compression. The good news is that we expect the downside to be somewhat short-lived.
With the Fed remaining firmly in the driver's seat, we think the market will continue to anticipate and price in all of the Fed's tightening moves rather quickly. It's been a hallmark of the high volatility regime. But as we begin to get signals of inflation becoming tamer and even a more material slowdown in interest rate increases from here, or even a Fed pause, we think multiples will begin to bounce back.
That's the power of monetary policy. In our view, a Fed pause is almost the same as a cut in the market's eye, which is probably worth 2 to 3 multiple points of valuation multiple expansion, all else equal.
