Investors Should Prepare for the Certainty of Uncertainty
Investors largely expected the Fed Chair to stress in his Jackson Hole speech that the central bank is more inclined to tighten monetary policy than pause or cut rates, given hawkish comments from other Fed officials at the Wyoming event prior to Powell’s speech. By most estimates, the market was prepared for Mr. Powell to outline a firm commitment to bringing inflation down and communicate there is still work to do on inflation (i.e., rates need to climb higher from here). And while the Fed Chair largely delivered on that consensus view, his brief speech on Friday morning sent shockwaves through the market, reminding investors that the Federal Reserve is a long way away from declaring “mission accomplished.”
In his eight-minute speech, the Fed Chair mentioned the word inflation forty-six times, using terms like “pain” to refer to the economy/labor market and “unconditional” in reference to the Fed’s commitment to fight inflation and restore price stability. Unfortunately, these are not the type of remarks that highlight an environment conducive to further stock gains. Thus, equities quickly sank lower on Friday, with the S&P 500 Index posting its worst day since June 13 and cementing its second straight week of losses. Notably, Mr. Powell stressed that monetary policy will likely be restrictive for some time, and the Fed will “keep at it until the job is done.” For investors specifically, the Fed Chair pointed out that history cautions loosening policy prematurely, a reference to the Arthur Burns era in the 1970s, where Fed policy inadequately addressed the inflation pressures of the day. Finally, and most critical to markets, Powell noted that the Fed’s fight against inflation would likely require a sustained period of below-trend growth in the economy (i.e., communicating the Fed is willing to cause a recession to break the back of inflation).
In our view, Mr. Powell used the Jackson Hole opportunity to bring investors back down to earth with the reality of the economic situation that the central bank faces today. Simply, to quell record-high inflation, the Fed will likely need to raise its fed funds target rate well into a restrictive zone, likely above 3.5%, which could erode demand enough to cause a recession. While that’s certainly not new news to most, that statement helps reground expectations, which appear to have been lost on some investors over the summer months amid such a strong stock rally. To be clear, the Fed is not readying a position to cool its tightening policy any time soon. On the contrary, rates are likely to climb higher from here. And the peak inflation/Fed-hawkishness dynamics that drove stocks higher this summer are likely a fading tailwind for asset prices moving into the fall.
Last week, the S&P 500 Index fell 4.0%, and the NASDAQ Composite dropped 4.4% for their worst week since June 17th. The Dow Jones Industrials Average also dropped by more than 4.0% on the week, with Growth (down 4.9%) underperforming Value (down 3.1%) for the third-straight week. Energy (+4.3%) was the only positive S&P 500 sector last week, as West Texas Intermediate (WTI) crude rose +2.5%. Treasuries were mostly weaker, with the curve flattening and the 2-year/10-year spread remaining inverted by roughly 37 basis points. Last week, the U.S. dollar firmed against the major currencies, and Gold finished lower by 0.7%.
In contrast to Powell’s tough talk on inflation last week, investors wrestled with economic data that showed price pressures continuing to moderate. First, August flash Purchasing Managers’ Index (PMI) reports showed composite (i.e., services and manufacturing) input prices rising at their slowest pace in the past year and a half. Second, the July personal consumption expenditure (PCE) price index showed headline PCE inflation coming down 0.1% month-over-month versus June’s increase of +0.1%. Third, the Fed’s preferred inflation gauge, Core PCE, rose just +0.1% m/m in July, a significant slowdown from the +0.6% pace recorded in June. Lastly, final Michigan consumer sentiment showed one-year inflation expectations declining by 0.2% to +4.8%, highlighting consumers believe price pressures will likely ease with time.
Historically, September is the S&P 500’s weakest month; investors should prepare for increased volatility
In our view, investors should prepare for increased stock volatility, lower growth trends, and continued uncertainty heading into the fall. While stocks may be able to muddle through until the next earnings season in October, and when seasonal factors improve, obvious near-term catalysts to drive stock prices higher appear lacking at the moment. Economic data, including Friday’s August nonfarm payrolls report, incoming inflation prints, and other consumer and business activity measures, could hold a larger influence on moving stocks around next month and ahead of the Federal Reserve’s policy decision on September 21.
September is also historically the S&P 500’s weakest month of the year. According to FactSet data, the S&P 500 has averaged a 0.4% decline in September over the last ten years. Additionally, September is the only month of the year the S&P 500 has averaged a negative return over the last ten years. In the previous 20 years, the S&P 500 has averaged a decline of 0.6% in September, posting significant monthly declines in 2021 and 2020 and following a solid performance during the summer months. On a brighter note, the October through December period tends to be a more favorable period for stocks historically, with the three-month total netting some of the S&P 500’s strongest average returns of the year.
But before investors can look to better seasonality trends starting in October, they will need to contend with the Federal Reserve nearly doubling the monthly pace of its balance sheet reduction strategy to $95 billion in September. At the same time, many S&P 500 companies (the largest buyer of stocks in the market) will move into a blackout period by mid-September and ahead of the earnings season in October. According to Goldman Sachs, this should slow the pace of share buybacks in the back half of September, with just over half of the S&P 500 impacted. And finally, earnings revisions for the third quarter could become a headwind for the major U.S. averages as analysts look to shore up their profit estimates before the Q3 reporting season begins in mid-October. Since the beginning of July, Q3’22 S&P 500 earnings per share (EPS) estimates have declined precipitously from +10.3% year-over-year to just +4.4% y/y. Still, solid earnings trends in 2022 (mainly supported by Energy) have been a strong support beam for stocks this year, and we believe will likely need to continue if equities can maintain current levels or move higher by year-end.
A high volume of economic data expected this week, including Friday’s jobs report
Looking ahead this week, trading volume should thin as the long Labor Day holiday weekend approaches, despite a heavy economic calendar. On Tuesday, the June S&P/Case-Shiller U.S. National Home Price Index is released, as is the July Jobs Openings and Labor Turnover Survey (JOLTS) report. While the JOLTS report acts with a two-month delay, the update on job openings should be influential nonetheless, as openings have been on the decline since April. August consumer confidence also hits on Tuesday and is expected to rise modestly from July levels. However, inflation components within the report are expected to drop from July levels after hitting an all-time high in June. This should help reinforce the idea that consumer inflation expectations continue to moderate. August Institute of Supply Management (ISM) manufacturing numbers will be released on Thursday and is expected to show activity again slowed this month versus July levels but remains in an expansionary condition.
But the critical report to watch is Friday’s August nonfarm payrolls report. The U.S. economy is expected to have created +290K jobs this month, down from the eye-popping +528K jobs created in July. The unemployment rate is expected to hold steady at 3.5%. Combined with the job openings data this week and the weekly update on initial jobless claims (which have steadily risen from the April lows), investors will be closely monitoring Friday’s nonfarm payrolls report to help shade expectations for either a 50 basis point or 75 basis point Fed hike next month. A hotter-than-expected August jobs number likely pushes market odds further toward a 75 basis point move, which stood at a roughly 67% chance based on the CME Group’s FedWatch Tool coming into the week.
Sources: FactSet and Bloomberg. FactSet and Bloomberg are independent investment research companies that compile and provide financial data and analytics to firms and investment professionals such as Ameriprise Financial and its analysts. They are not affiliated with Ameriprise Financial, Inc.
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