The speaker at a lecture I recently attended was very well educated, with a Ph.D. in Economics from Stanford. He opened with obligatory humor, saying that although he was a Ph.D. he did not put “Dr” in front of his name. He joked that this was because he couldn’t save anyone if someone yelled “is there a doctor in the house?”. He went on to say that the only person he thought he might be able to save would be a hedge fund manager having a heart attack by saying “the Fed is pivoting”. The room erupted in laughter. It got me thinking about how much monetary policy affects market psychology. And how much the returns in 2023 so far have been driven by anticipated Fed policy action. With the market trading at a forward price-to-earnings ratio of nearly 18x, a Fed that is steadfast in holding off inflation, and a deceleration of corporate earnings, there appears to be a disconnect between investor sentiment and fundamentals. It seems as if the markets want to have their cake and eat it too. Let me explain.
To start with, let’s look at the shape of the yield curve over the next two years. It is humped, like a camel; first rising, then falling.
Source: Income, Research, & Management, Bloomberg
To me this represents the idea that the bond market anticipates a few more quarter-point rate hikes, followed by rate cuts later in the year. At the same time, though, the Fed does not appear to be giving any indication it will “pivot” to rate cuts anytime soon. It does not seem likely that the Fed would go to such great lengths in raising rates to cut economic activity and control inflation, and then turn right around and cut rates within 3-6 months. Perhaps the Market thinks this because corporate profits are weakening. With roughly two thirds of S&P 500 companies having already reported 4th quarter earnings, positive earnings surprises are below average and profit growth is on track to decline about 5% year-over-year for the final quarter of 2022. So, with potentially weak profits on the horizon, does this mean the Fed will cut rates soon? Is this why equity markets have moved higher this year? If markets were cheap, I might say the recovery in equity markets this year makes sense. But the S&P 500 is clearly above fair value now. In all recessions since 1970, except for the 1990 downturn, profits recessions also produced negative equity market returns.
Rising equity prices in a period of weak profit outlook simply pull forward future returns to the present time. The implication is that future good news, assuming good news happens, is already baked in— leaving little room for error. If markets anticipate a “goldilocks soft landing scenario” in which we don’t go into a recession —a key premise underlying 2023’s stock rally—then the Fed may pause rate hikes . But is a pivot in the offing? Seems unlikely. A soft landing AND a fed pivot? I wish I had a nickel for every time my mom said “Oh, so you want have your cake and eat it, too.” I think I finally understand what she meant! Our view is that we recommend sticking to allocation targets and rebalancing if portfolio allocations meet the upper end of the risk target ranges. Please let us know if you have any questions or would like to talk about your portfolio.
