When will the Fed pivot?

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   By Guest Blogger Ryan Lewenza

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One of the key aspects of our roles as Portfolio Managers is to try to filter out the noise (stuff that is not critical to the economy and markets) from what is actually driving the global economy and financial markets.

Without a doubt the most important factor driving the US equity markets is when will inflation peak and rollover, which, in turn, will drive the decision by the Federal Reserve (Fed) to ‘pivot’ and stop hiking rates. Everything (the economy, stock and bond prices, crypto etc.) all hinges off this decision and timing.

I’m going on the record to declare that inflation has likely peaked (hopefully I don’t have to eat some humble pie with this declaration) and therefore I believe the Fed (and Bank of Canada) are getting close to pausing the rate hikes. More specifically, I believe interest rates could peak soon and I’m targeting roughly Q1/23. If correct, this should start to put a floor under the economy and equity markets, and ignite a recovery for both in 2023.

There are two types of inflation – headline which includes food and energy and core inflation which strips food and energy out. Headline inflation has already peaked. It hit a peak of 9.1% y/y in June, 8.5% in July, 8.3% in Aug and 8.2% in Sept. Why is this coming down?

Primarily because commodities and gasoline prices are falling. Oil peaked at $125/bbl. and today sits at $85. Copper is down from $5 to $3.5. Lumber is down 70% from its peak.

But core inflation remains hot at 6.6% y/y, which is what the Fed is most focused on. But I see this rolling over soon as well.

First, a number of individual inflation measures are rolling over (see table). For example, US wages have peaked. They hit at a high of 6.7% y/y early this year and now stand at 5.8%. Used vehicles went through the roof following the pandemic and were up over 50% y/y at the peak.

That’s nuts! As of October used car prices are down 10% y/y. Freight costs to move containers peaked at $10,000 per container and today sits at $3,145.

Lastly, a big component of core inflation is dwelling costs and US home prices are declining and I see rent prices cooling off as well they typically lag behind home prices.

So across a broad number of indicators, inflation looks to have peaked and I see monthly declines coming in US inflation readings in the coming months. This should then allow the Fed to take the foot off the pedal and stop hiking rates, which I see happening in the first quarter of next year. If correct, rates should peak over the next 3-6 months, which should then lead to a recovery in stock and bond prices

Key Inflation Indicators Pointing to a Peak

Click to enlarge. Source: Bloomberg, Turner Investments

The market seems to agree with this view as it is currently pricing in a peak in the fed funds rate of 5% by mid-2023. With the Fed’s 75 bps rate hike this week the fed funds rate now sits at 3.75-4%. In the Fed’s statement it hinted that the Fed could start to slow its rate hikes, essentially signaling a ‘step-down’ in future rate hikes.

This is exactly how the Fed operates. They start to tweak the language in their statements, and have Fed Presidents start to socialize the idea of adjusting their policy decisions, rather than making abrupt changes. They telegraph these changes to the markets and I think this week’s announcement and statement is the start of this process.

Currently the market is pricing in another 50 bps rate hike in December, followed by another 25 bps hike in January, with a peak of rates in in the spring. So we’re getting closer to the end of this cycle, in my view.

Market Expects a Peak in Fed Funds Rate in 2023

Source: Bloomberg, Turner Investments

Ok, so now that we have a potential playbook for interest rates in the coming months I need to connect this with the equity markets.

Below is the most important chart for the equity markets that illustrates the critical relationship between interest rates and the stock market. Below I overlay US interest rates (US Government 10-year real yields) with the S&P 500 price-to-earnings (P/E) ratio. I need to explain this chart so readers understand this connection.

In the chart I invert US interest rates to better show the relationship. This is the green line and means that as interest rates rise, the line is actually declining on the chart. So as the Fed hikes rates, this weighs on stock prices, and the P/E ratio for the S&P 500 contracts. But play this chart forward. As the Fed pauses and/or potentially ends their rate hikes, the stock market should start to recover, with the P/E ratio expanding.

This is what I see playing out next year and why I see a stock market recovery. Everyone these days are talking about a recession coming in 2023. But 1) much of the expected recession is already priced in the markets; 2) the stock market leads the economy by 6-9 months; and 3) as this chart shows, interest rates are a key driver of stock prices so if interest rates peak and decline next year as I expect, this should lead to a recovery in the stock market.

So there’s the playbook for 2023. Stay tuned for future updates.

Link Between Interest Rates & the US Stock Market

Source: Bloomberg, Turner Investments

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.