Despite early hopes for a positive day as measured by S&P futures pre-market trading, the mood was soon dashed as markets declined sharply. The S&P fell over -4%, with the NASDAQ off by over -5%. What happened? In short, inflation fears and frustrations.
This has been an ongoing story this year, but this morning’s Consumer Price Index [1] release for August disappointed relative to market estimates, which had been pegged to a flat to slightly lower reading. Instead, while energy prices fell -5% last month, prices for food, medical services, and shelter all rose sharply. This has delayed a long hoped-for peaking in CPI, with trailing 12-month headline and core readings coming in at 8.3% and 6.3%, respectively. The jump in the pace of core CPI by 0.40% especially was a surprise.
Being on the cusp of the September Federal Reserve meeting next week, this raised the chances of an even larger hike in the fed funds rate. Based on futures markets [2], the assumed chances a month ago of ‘just’ a 0.50% hike have morphed towards a likely 0.75% (to 3.00-3.25%). This has carried on to an expected similar 0.75% hike in November, and greater uncertainty about December’s meeting. The key word there is ‘uncertainty’, which bothers markets to a much greater degree than ‘knowing’ (even if it means a certainty of bad news). The Fed has communicated that it intends to fight inflation to a degree that could even cause greater ‘pain’ to the economy, but the ending point is what remains in question. Those same futures markets have seen a rise in expected fed funds rate levels for mid-year 2023 rise from around 3.50% to now 4.00-4.50%, although this represents a new assumed peak, with rising chances for a cut later in the year. What’s still unclear is the Fed’s ‘terminal rate’, and how high that rate needs to go before the Fed ‘breaks’ the economy in the process of breaking inflation, which markets assume may have to happen. That’s not a foregone conclusion, but the longer the hawkish policy lasts, the better the chances. Of course, it gets complicated at that point. If an ensuing recession occurs, and is damaging enough, the Fed would need to reverse course and cut rates—negating the very impact of the current hiking path. If this sounds like a tricky situation for the Fed to get right, it is.
Ultimately, higher rates are troublesome because they raise the discount rates used to value a variety of risk assets, including stocks and real estate. The elevated discount rates shrink the value of future cash flows, and thereby lower current ‘fair values’. With economic slowing already happening, and some expectations for lowered earnings forecasts later this year, this adds even more uncertainty to these underlying valuations. Uncertainty in these inputs creates volatility as various scenarios are re-modeled, but it doesn’t last indefinitely. But it may mean the recent rally from the Jan.-Jun. -23% bear drawdown was overly optimistic. Bottoms can take time to solidify, often taking several ‘tries’, but -25% to -30% represents the median drawdown associated with post-WWII recessions. Autumn is a classic time for market volatility, with September showing the poorest results (since 1926), but October-December far better. Every year and cycle plays out in a different storyline, but getting bad news out of the way (with sentiment already poor) has some benefits, with the ability to start a new cycle with a clean slate at more attractive valuations. In addition, extremely negative sentiment and geopolitical conditions abroad have brought foreign stock valuations down to recessionary-like levels. And lastly, bonds have become more attractive than they have in some time, featuring newly higher yields, although volatility might hang around there as long as the Fed remains hawkish in the near-term.
Ryan M. Long, CFA
Director of Investments
FocusPoint Solutions, Inc.
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Sources:
Ryan M. Long, CFA; Director of Investments; FocusPoint Solutions, Inc.
[1] U.S. Bureau of Labor Statistics
[2] CME Group (https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html)