By Ellen Hazen, CFA®, Chief Market Strategist

August 31, 2022

August Takeaways:

• The cumulative effect of the Federal Reserve’s (Fed) tightening year-to-date is being reflected in a variety of economic indicators, just a few of which are the Purchasing Manager Index, the Consumer Price Index, both New and Existing Home Sales, and the Leading Economic Indicators
• Inflation may be easing. The July CPI softened a bit from June’s 9.1% to 8.5%
• Crucially, the labor market remains a strong datapoint, counteracting the negative datapoints above. Jobs created in July increased by 528,000, and the unemployment rate declined again, by 0.1%, to 3.5%, matching the pre-COVID February 2020 level
• At the Jackson Hole economic summit, Fed Chair Jerome Powell firmly and unequivocally stated the Fed’s intention to keep rates high for as long as necessary to tame inflation. This was reinforced in statements by numerous other Fed officials both before and after Powell’s speech
• Atlanta Fed GDPNow indicator bounced back to a respectable 1.6% for Q3

We expect economic growth to continue to slow, which suggests that investments should be focused on high quality areas that can continue to grow with a less favorable economic tailwind.

We expect continued volatility in the equity markets for the remainder of the year. This is likely to be accompanied by continued rotation among various segments: US, international, small, large, growth, value.

We expect real yields to continue to increase. Selectivity is key in fixed income securities, and our bias is toward higher quality and shorter duration credits. Additionally, rising real rates have negative implications for stock multiples.

What We Are Watching for in September:

• Fed meeting on September 21 – a 50 or 75 basis point increase? Various Fed officials have publicly declared both their individual expectation for the size of a September increase, and where they would like short-term rates to be at the end of 2022
• August jobs data will be released September 2
• We would not be surprised to see corporate earnings estimates revised further downward as real rates continue to increase, consumers continue to be cautious, and management teams face the reality of continued negative operating leverage

We entered the year expecting higher volatility than we saw in 2021, and this has been playing out in spades, not just in the equity markets but also in fixed income markets. This volatility has been exacerbated by even higher than expected inflation, driving the Fed to raise rates more quickly than expected, and leading to what may be a significant Fed-induced slowdown.

Goodbye Pivot, Goodbye Put

A month ago, the bond market was pricing in a maximum Fed Funds rate of 3.30% in February of 2023, followed swiftly by rate cuts in March and April. Despite Fed officials’ statements after the July Fed meeting in which they insisted that they do not plan to start cutting rates until it is clear that inflation is headed back toward its 2% target, the equity market rallied after Powell’s July press conference. At the same time, the rates market was pricing in cuts early next year: the so-called “pivot,” where the Fed pivots from increasing rates to instead cutting rates.

Today, after Powell’s Jackson Hole speech, the bond market is predicting that rates will peak at a much higher rate, 3.90%, and in April. Cuts are still expected, but they will be smaller and later than the month-ago expectation.

Similarly, equity markets tumbled after Powell’s speech, reflecting the dawning realization that rates may in fact stay higher for longer and that the Fed is willing to risk a recession to tame inflation. Although this may lead to equity volatility in the near term, it is a healthy development and one that is likely necessary for a healthy market.

As far as the so-called “Fed Put,” which expresses the market’s belief that the Fed will quickly step in to ameliorate any equity market declines, we now have a line from Richmond Fed President Thomas Barkin’s recent speech: “There is a path to getting inflation under control. But […] a recession could happen in the process […]. No one canceled the business cycle.”

Rising Real Rates Are Compressing Equity Multiples

It’s easy to forget how unusual negative real interest rates are. After the Fed cut rates to zero during the pandemic, the long end of the curve followed down, and 10-year real rates turned sharply negative starting in February 2020. Prior to that, however, the only other period of negative real rates was during the 2013 “taper tantrum.” Because the Fed is so focused on reducing inflation, we expect real rates to remain positive for the near-to-intermediate term. On a year-to-date basis, the impact of rising rates on price-to-earnings multiples is apparent (see graph).

We saw evidence of this during the month of August: the real 10-year rate, as measured by the 10-year Treasury Inflation Protected Security (TIPS), increased from 0.1% to 0.71%, while the S&P500 multiple decreased from 18.2x to 17.4x.

This chart illustrates the inverse relationship between the real 10-year Treasury rate and the S&P500 over the past few years.

As long as real rates continue to rise, we expect equity volatility to continue in tandem.

Equities Reflecting No-Longer-Ignorable Negative Operating Leverage

Q2 2022 earnings showed negative operating leverage, which is when earnings grow more slowly than revenue. This quarter, S&P500 revenue grew +13.7% while earnings grew only +7.1%. This was a broad phenomenon, with nine of the eleven S&P industry sectors exhibiting negative operating leverage. Only the energy sector and the industrials sector produced earnings growth above revenue growth. Those sectors most sensitive to the economy had the worst earnings growth relative to revenue growth: the financials sector, the consumer discretionary sector, and the communications sectors all had negative earnings growth even as revenue increased. July (off-quarter) earnings reports from retailers provided additional evidence that consumers are spending less. Inventories at many retailers ballooned.

As for performance in the month of August, the S&P500 declined 4.2%, which was entirely multiple contraction: the multiple contracted by 4.4%, while the forward twelve-month estimate increased just a touch. All the decline occurred after the Fed July minutes came out on August 17 – prior to that, most equity indices had actually been up 3-4% for the month. The Fed minutes had no mention of a pivot, hence the market disappointment. We saw further rotation among various sub-asset classes: US large cap growth stocks reverted to underperforming large cap value stocks, small cap stocks outperformed large cap stocks, and international stocks were bifurcated, with emerging market stocks actually up 0.2% during the month, while developed market stocks underperformed US stocks.

In this dynamic environment, we believe that investors should stay high-quality, and seek to exploit market volatility by buying assets when they are attractively valued. We expect this will create more opportunities for tactical investing than we have seen in some time. As long as the consumer and the labor market remain healthy, we believe a deep recession is unlikely.

Disclosures