Equities Anticipate a Powell Pause
Equities began the year strongly, moving up 6% in January as investors anticipated a more accommodative Fed and traders bought the most beaten down names of 2022. Part of the move was seasonal, as investors put new money to work after extensive tax loss sales of 2022. This was exacerbated by algorithmic trend traders as well; once there was a slight upward trend these “machines” began buying, driving stocks higher (of course the same trend traders will exacerbate the downtrend once a reversal sets in). Meanwhile, fundamental investors remain underweight and skeptical. But FOMO increasingly draws more of them in, creating further upward pressure.
Meanwhile, U.S. 10-year treasury yields fell 36 basis points in January. Like equities, treasuries anticipated lower inflation and a more dovish Fed. In a sign of how much bond investors disagree with the Fed, fed fund futures—where traders can wager on the future direction of Fed actions— anticipated two FOMC cuts in the back half of 2023. This contrasts with the FOMC’s own projections for steady rates in 2H23.
While there is no doubt inflation is slowing, it is not clear that it will drop fast enough to appease the Fed. Fed Chair Powell has noted numerous times his focus is on core services inflation ex-housing, which remains solid. In fact, January payrolls (released February 3) were incredibly strong at 517,000, more than double economist’s expectations! Much of the strength stemmed from service industries.
The payroll release brought an abrupt halt to the prior day’s euphoria over Powell’s Q&A, where he inexplicably fumbled his answer to a question about easing financial conditions (recall the Fed wants tighter financial conditions—i.e. lower equities and higher treasury rates—in order to slow the economy).
Another key release on February 3rd, ISM Services—one of the best forward looking economic indicators for the services economy—rebounded strongly in January after indicating contraction in December. As a result, investors are receiving mixed signals. On one hand inflation is slowing and ISM Manufacturing surveys (sister to ISM Services) have shown contraction for 3 months as consumers pull back on goods purchased during the pandemic. On the other hand, ISM Services and payrolls are showing strength.
Given that Powell has mentioned multiple times that he intends to err on the side of caution regarding inflation—that is, he’d rather have a recession than prolonged inflation—we think it unlikely that the Fed reverses course early vs. late. However, it is always possible for economic releases to surprise, as we saw last week. So, while we are participating in the recent equity runup, we are cautious as we think the recent move has been a bit overdone with PEs now over 18x 2023’s (likely to be revised lower) EPS estimates. Additionally, we keep one phrase in the back of our minds: Don’t fight the Fed.
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