Equity markets remain in a volatile trading range

Thoughts

• Equity markets look to rebound into year-end, following a weak start to December. Markets remain on an emotional roller coaster, driven in the short term by shifting views on the Fed and the economy, though markets have been in an increasingly narrow trading range since May. With FOMC, inflation, and earnings data now past, investors have a dearth of market-moving data during a period when volume tends to fade and volatility is elevated. Interest rates are rebounding following a sharp decline that saw the 10-year yield fall nearly 1% since late October.
• As 2022 trading approaches its conclusion, investors are focusing on positioning in 2023. Equity market strength during the fourth quarter could force institutional investors to sell up to $100 billion in equities through year-end to keep allocations in line with targets. Institutional investors remain quite bearish, with a near-record-low net 69% of respondents expecting weaker global growth, historic weakness expected in corporate earnings, and cash levels near record highs at 5.9%, per Bank of America’s Fund Manager Survey. Hawkish sentiment during the FOMC and ECB meetings last week has the focus shifting from inflation to growth. Deteriorating earnings estimates for next year have many wondering what the true valuation is for equity markets. Bulls continue to focus on relative versus absolute data, with inflation likely to have peaked, fundamental data stronger than feared, and gradually shifting FOMC policy.
• In 2022, market moves were driven by fear rather than fundamentals. Rising inflation, Covid lockdowns in China, geopolitical tensions and more all contributed to emotional decision-making. Looking ahead to 2023, we expect to see an increased focus on the fundamentals, particularly macro data and earnings. While we have seen a deterioration in both, we have reason to believe that expectations are more pessimistic than they should be because the worst fears have already been priced in.

News

• Data is increasingly reflecting a slowing economy, led by the sharpest deceleration in retail sales (-0.6%) this year. Consumers are reacting to macro worries, housing weakness, and stubborn inflation, pulling back on holiday-related buying, home improvement, and autos. Industrial production, manufacturing, and Fed surveys from New York and Philadelphia showed contraction. Despite the weak patch, the Atlanta Fed’s GDPNow Model still forecasts growth in the fourth quarter of 2.8%, and the Citi Economic Surprise Index remains positive. PMI data was disappointing, with both manufacturing (46.2) and services (44.4) reflecting contraction and the composite at the lowest level since May 2020 (44.6). In Europe, however, the flash composite PMI reading hit a four-month high.
• Consumer price inflation came in softer than expected for the second month, driven by a sharp decline in core goods prices. Headline CPI rose by 7.1% from a year ago, while core CPI (excluding food and energy) rose 6.0%. Inflation expectations continue to moderate, with the NY Fed Survey showing the lowest level since August 2021, and the 5-year breakeven down to just 2.2%, the lowest level since February 2021. Rents are slowing, with Zillow data showing reflecting the sharpest decline in the seven-year history of the survey at -0.4%. This will have a lagged impact on CPI due to the calculation. The so-called Consumer Stress Indicator (including food at home, mortgage rates, and gasoline) is at 22.2%, down just fractionally from the recent high and near the highest level since the early 1980s.
• The FOMC voted to hike the Fed Funds rate by 0.5% to 4.5% at the top end, reiterating their commitment to “stay the course until the job is done.” The “dot plot” shows 17 of 19 respondents see a terminal rate above 5.0%, falling to just above 4.0% by the end of 2024. This is slightly more hawkish with the Fed Futures curve, which shows a peak of 4.9% in May, before falling by 0.7% (three 0.25% cuts) by the end of 2023. The curve embeds a 75% chance of a 0.25% hike at the next meeting on February 1, with a one-in-four chance of another 0.5% hike. In Chair Powell’s press conference, he did not completely discount the potential to adjust the 2% inflation target.

What to Watch

• A busy week of data awaits in what could be another volatile week ahead of the Christmas holiday. Housing data is plentiful, including the NAHB Housing Market Index, housing starts, and existing home sales. Other notable data include consumer confidence Wednesday, revised GDP and leading indicators on Thursday, and durable goods, personal spending and income, and the PCE deflator (Fed’s preferred inflation metric) on Friday.