2022 has been a roller-coaster ride in more ways than one. Case in point: In recent months, US equity-market participants have pounced on any signs that the US Federal Reserve (Fed) might be becoming less hawkish, sending the market soaring for brief intervals, only to be disappointed when the Fed pushes back on the notion that its words or actions signal a policy pivot. US stocks just completed a very strong November, but there are two big reasons why I think this latest market rally will disappoint yet again (and, indeed, already has as of the first week of December):
1. The Fed funds1 futures market is still pricing in Fed interest-rate cuts (not hikes) in the latter half of 2023.
2. Corporate earnings estimates haven’t come down far enough for me to wave the all-clear sign on US equities.
Wishful Thinking on Rates?
Following Fed Chair Jerome Powell’s much-ballyhooed November 30 speech, many investors gleefully focused on the Fed’s planned shift to a 50-basis point2 (bps) rate hike from the outsized 75-bps hikes enacted at the past four Federal Open Market Committee meetings. However, Powell also emphasized that even though there has been some better news recently on core goods inflation, non-housing services inflation—which represents more than 50% of core inflation—has remained high and sticky. Importantly, this is also the area where wages have risen the most.
From where I sit, here’s what the equity market seems to have missed: Fed policy likely needs to be held at restrictive levels for “some time” before demand and wages slow enough to warrant looser policy. As of December 7, the futures market was pricing in a peak Fed funds rate of 5.0% and then around 50 bps of rate cuts by the end of next year. Given persistent structural issues around labor supply (e.g., a lower workforce participation rate), I think it’s optimistic to believe inflation will have cooled sufficiently for the Fed to be able to pivot to policy easing by next year.
Too Rosy on Corporate Earnings?
On the earnings front, the equity market also seems to have a pretty rosy outlook. Earnings expectations for 2023 have fallen quite a bit this year, to 3.8% for S&P 500 Index3 companies as of early December, from 9% roughly six months ago (according to FactSet). However, FIGURE 1 shows that analysts’ earnings expectations may have to be pared back even further before hitting the recessionary levels seen over the past three decades. (Earnings “breadth” better captures the condition of the overall market, in my view.) Even in a mild recession, one would expect earnings to contract and their breadth to deteriorate, suggesting that the market may be too optimistic regarding the fundamental earnings picture.