The market's megaphone message for the Fed

11/13/2023 — Equity markets were mixed this week, with the S&P 500® Index managing a gain for the second week, gaining 1% and closing at the best level in two months. Bulls are focused on healthy macro data, improving seasonality, and extremely pessimistic sentiment and positioning, while bears argue that Fed policy remains uncertain, recession indicators continue to flash, and consumer data is beginning to suggest a slowdown. Earnings revisions further complicate this debate, with fourth-quarter estimates being revised lower but 2024 estimates remaining resilient. Investors have softened their reactions to data in recent weeks, with significantly less volatility. The degree of pessimism in sentiment and positioning is reminiscent of last year, which led to a substantial contrarian rally.

Earnings season has largely come to a close, with 92% of the S&P 500 companies having reported third-quarter earnings. The "beat" rate for earnings of 81% is the strongest in two years, with 61% having beat revenue estimates. The blended growth rate of 4% and margins expanded for the first quarter since 2021. Management commentary was cautious, resulting in growth expectations falling from 8% at the end of the third quarter to 3% currently. Estimates for 2024 remain resilient, however, with growth of 11% predicted. The next 12-month outlook for earnings for the S&P 500 is at a record $242, bringing the PE ratio to 18x, which is in line with the average from the past decade.

The market opening down this morning comes after Moody’s warned of a US debt downgrade amid ongoing appropriations battles in Congress, invoking an emotional response from investors. This comes during another developing stand-off, as the markets do their best to challenge the Fed’s commitment to tight fiscal policy, amid budding investor confidence in the economy. Following Chairman Powell’s suggestion that the FOMC may yet raise rates further, markets took a quick pause Thursday, only to rebound strongly on Friday, demonstrating the challenge for the Federal Reserve. It’s the financial market equivalent of a shouting match. As with most shouting matches, the quiet truth is likely somewhere in the middle.

News

Macro data is softening, with consumer spending beginning to slow and bank data suggesting increasing conservatism. Consumer sentiment is at the lowest level in six months as long-term inflation expectations jumped to the highest level in 12 years. Bank of America data showed a 1% decline in card spending in October compared with a year ago despite inflation acting as a 4% tailwind. Commercial and industrial loans shrank by 0.2% in September, marking the sixth straight monthly decline as financial conditions tightened and demand softened. The Citigroup Economic Surprise is still strong at +50, while the Atlanta Fed’s GDPNow model indicates fourth-quarter growth of 2.1%, not consistent with a recession.

Fed Chair Powell’s speech on Thursday resulted in the S&P 500 breaking its winning streak, as he said that the FOMC is "not confident" that policy is tight enough to bring inflation down to the 2% target. "If it becomes appropriate to tighten policy further, we will not hesitate to do so," Powell said in comments to an International Monetary Fund conference. "We will continue to move carefully, however, allowing us to address both the risk of being misled by a few good months of data, and the risk of overtightening," he said. This, along with a poorly received 30-year Treasury auction (weakest demand since 2016), resulted in bond market volatility. The Fed Futures curve implies a rate of 4.40% as of January 2025, which is a net four cuts from here, and is unchanged from the beginning of the month. Some suggest that Powell’s hawkish comments were a reaction to loosening financial conditions in recent weeks.

The Federal government faces a possible shutdown this week if a spending deal is not struck. New House Speaker Johnson suggested a "laddered" approach, funding some parts of the government through mid-December and others through mid-January. His job is difficult, as there is little alignment among the GOP caucus, much less bipartisanship between the parties. Senate Democrats are working on a continuing resolution through mid-December, setting up a fight around the holidays. The betting markets are pricing in a 40% shutdown in November, up from less than 25% at the end of October. Historically, shutdowns have been short in duration and limited in economic or market impact. Moody’s placed a "negative outlook" on the US Treasury due to rising deficits and political polarization, potentially joining S&P and Fitch in downgrading the debt.

What to watch

Inflation data will be closely watched this week, with CPI on Tuesday and PPI on Wednesday. Other notable releases include NFIB Small Business Index on Tuesday, retail sales on Wednesday, industrial production on Thursday, and housing starts on Friday.