Market Insights: Is the Market Telling Us the Worst is Behind Us?
Michael Carrico, CFP®,CRPC®, Wealth Manager
Last Thursday was the largest single day gain (+5.54%) for the S&P 500 Index since 2020. The Nasdaq Composite (+7.35%) and Dow Jones Industrial Average (+3.69%) had similarly high-flying performance. So, what happened on Thursday, what should we take away from it, and what does that mean going forward?
What Happened Last Thursday?
First, let’s look at what happened on Thursday, and I will start by saying that the markets and economy are complex machines. While we can examine some potential suspects that moved the market on November 10, I will not claim to know the full story.
The headline is that the appropriately named “headline inflation” numbers were better than expected. The US Consumer Price Index year-over-year (US CPI YoY) change has been a closely watched economic indicator for the last year. The expectation was for a 7.9% increase in consumer prices from last October. Inflation surprised to the downside coming in at “only” 7.75% YoY change. It appears that the market reacted positively to this news. So why were markets up 3-7% on the news that prices for consumers increased by 7.75% over the last year? After all, the Fed’s target is 2%, isn’t it?
The Fed, and specifically Fed Chair Jerome Powell, have been clear with messaging that they aim to get inflation under control. On November 2, the Federal Reserve increased interest rate targets by 0.75% as expected. That same day Jerome Powell said the Fed anticipates “…ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” This was in line with the messaging in September, except that he added, “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” In essence, he softened the message a bit, perhaps opening the door to the possibility that the Fed may slow rate hikes if they see certain indications that the economy is cooling, and inflation is coming under control.
So, inflation came down faster than expected and this was the fourth straight month of decreasing inflation readings. The markets will always be trying to predict the future, and everyone wants to be the first to make the smart trade. It appears that the market interpreted this as sufficient “economic and financial developments” to move the Fed to slow the rate of interest rate increases, pause the increases or even, to the most optimistic predictors, pivot and begin decreasing rates earlier than expected. Some other factors may have been at play as well. Traders holding short positions may have decided to cover those positions in the wake of the news which introduces buyers into the market. Investor sentiment, as measured by the CNN Fear & Greed Index was improving throughout October but was at a relative low point on November 9 leading up to the release of inflation data, so good news was well received.
That is a brief overview of what happened, but what does that mean going forward? Inflation is not the whole story, so let’s look at some other factors we may want to consider.
What Are We Watching Going Forward?
The Fed is the bear on the trading floor these days and, while it is interested in inflation as a lagging indicator of a cooling economy and its primary policy target, it wants to see an overall “tightening of financial conditions.” Case in point, on Monday, Christopher Waller of the Federal Reserve Board of Governors said “The market seems to have gotten way out in front over this one CPI report. Everybody should just take a deep breath, calm down. We’ve got a ways to go.”
One major indicator The Fed is watching is the US unemployment rate. When unemployment increases, consumers have less discretionary spending power, and this leads to falling demand which is disinflationary. A related factor the Fed wants to see is slowing wage growth. Fortunately for US workers, but unfortunately for US investors banking on a near-term Fed pivot, US employment remains strong and has not moved much this year. As of October 31, the US unemployment rate was 3.7% and it has fluctuated in a narrow band between 3.5-4.0%. This is historically low given that the long-term average is 5.74% going back to about 1950. Although unemployment is a lagging economic indicator and confirms rather than predicts the direction of the economy, the Fed wants to see tightening labor conditions (i.e., higher unemployment and falling wages). Initial jobless claims reported yesterday were 222k which was under the median expectation of 225k and down from the prior week report of 226k. There has not been a confirmed meaningful increase in unemployment claims year-to-date. Rising unemployment tends to coincide with worsening economic conditions such as falling corporate earnings and falling household income and savings balances.
The US Unemployment Rate
Another consideration is that markets may have already priced in expectations of falling inflation and a less hawkish Fed—perhaps a bit too much according to Mr. Waller. If investors are banking on downside inflation surprises to spur additional major market rallies, they may be disappointed. Economists adjust their expectations based on new data, so this surprise to the downside may cause future expectations to be more aggressive and, therefore, less likely to be surpassed. The bottom line is that the Fed must be convinced that conditions are tightening before it will ease its policy stance.
There are (at least) two scenarios that may play out from here. One is the “soft landing” narrative in which inflation continues to fall consistently and significantly which leads the Fed to pause rate hikes and even pivot to reducing interest rates sooner than currently expected. In this scenario unemployment rates would increase slowly while wage growth slows and corporate earnings moderate, but the US avoids recession. The second is that inflation remains high, the Fed stays its hawkish course, and the US ends up in a recession with those factors all changing at a greater clip. The soft landing may be hard to stick. Going back to 1950, the US has not historically avoided a recession when inflation has exceeded 5%. The red line on the graph below shows the approximate 5% mark and shaded grey areas show recessions.
Consumer Price Index YoY
Of course, we do not know which scenario will play out and each day brings new information that may change the story. However, one lesson we can take away from the action last Thursday is that time in the market is more important than timing the market. As we have discussed recently in this newsletter, some of the best days of stock market returns occur shortly after the worst. Specifically, in the 20-year period between January 2002 and January 2022, seven of the ten best single-day returns for the S&P 500 Index occurred within 15 days of the worst ten single-day losses.
At Howe & Rusling we are actively monitoring economic and market conditions. Regardless of what comes tomorrow or next week, we are working to position our client portfolios to benefit in the long term. We still see headwinds for the stock market and remain underweight equities. However, we continue to look for opportunities in change. Often after a market peak, there is a changing of the guard. The high inflation and high interest rates of today may not benefit the same companies that lead the last bull market during a period of historically low inflation and interest rates. As always, we will take advantage of market opportunities to reposition the portfolio to coincide with our outlook. We are here for you and will continue to invest for your future, whatever that future may hold.
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