Wentz Weekly Insights
Slower Pace of Rate Hikes Ahead, But Higher Peak Rate
Stocks started last week with the Dow closing out the month of October for its best monthly performance since 1976, gaining 13.95%. However, stocks moved lower throughout the week as economic data on the labor market came in better than expected while the Federal Reserve suggested a higher peak/terminal rate, although acknowledged the pace of rate increases would slow.
The DOL said there were 10.7 million job openings as of the last business day of September. This is good, as it fell from the record high of 11.9 million in March, but not welcoming as it increased 500k from August and was almost one million more than expected. Layoffs remained low, while quits remain at unusually high levels, indicating workers’ willingness and ability to switch to a better or higher paying job.
Then, Friday’s October employment report showed the number of jobs created was a more than expected 261,000 while wages grew 0.4% in the month, also more than expected. With a tight labor market that continues to surprise to the upside, and wages that continue to rise at an above-trend pace, there is the concern inflation will stay high and that will encourage the Fed to keep its foot on the brakes.
This is exactly what happen in the Fed’s most recent meeting last week. As expected, the policymaking committee of the Federal Reserve, the Federal Open Market Committee (FOMC), raised the Federal Funds rate by 75 basis points (bps – one equals one hundredth of a one percent) to a new range of 3.75% to 4.00%. In our view, the Fed used this meeting as an opportunity to introduce the idea of slowing down the pace of tightening financial conditions and paving the way for smaller rate increases in upcoming meetings, while remaining hawkish by staying tough on inflation.
Market participants were expecting the Fed in some way to suggest the pace of rate increases would slow, and that is what was seen in the FOMC’s policy statement. The four-paragraph statement included new verbiage, stating policy needs to be “sufficiently restrictive” to bring inflation down while saying the committee will “take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” With stocks kneejerk reaction higher and bond yields move lower, markets took the statement as more dovish as it acknowledged the lag effect higher interest rates have on economic conditions and that meant the Fed would have to see higher rates work its way through the economy, which meant slowing rate increases, or pausing, to see the impact before tightening too far. The general thought is it takes at least 12 months to see the cumulative effects of monetary policy changes such as higher interest rates.
However, as with previous meetings, Chairman Powell’s press conference provided more color and leaned more hawkish, leading to a 2.5% decline in stocks for the day. Powell noted strong labor market and CPI reports since its last meeting in September and said the better than expected data “suggest to me that we will ultimately move to higher levels than we thought in the September meeting,” in other words, policymakers believe the peak rate is higher than what they thought at the September meeting. There were multiple times Powell acknowledged the lag between monetary policy changes and economic activity, indicating the Committee’s desire to see how higher rates work through the system. Powell said he does not think the Fed overtightened or moved to fast and likes where they’re at and how fast they got there. Powell reiterated his willingness to overtighten as the risks of doing too little and having inflation become entrenched far outweigh the risks of doing too much and the economy falling into a recession.
It was also important to note policymakers believe the speed of hikes is becoming less important, but it is still “very premature to think about pausing” and the more “important question now is how far to go.” The Fed checked the box with how fast to raise rates, it is getting closer to checking the box on how high to raise rates, the next question becomes how long rates need to stay high.
We believe the peak rate, or the rate at which the Fed is done, is closer to 5% and is important as that is what the markets are projecting. However, there is still the acknowledgment there is uncertainty about what level of the funds rate is “sufficiently restrictive.” Because of this uncertainty, along with the uncertainty of future profits after a very mixed earnings season, among other reasons, stocks will continue to be on a volatile path as we near the end of 2022.
One thing the markets will have more certainty on by the end of the week though, is the results of tomorrow’s Midterm elections. Republicans are still favored to take control of the House with a majority, but the race for the Senate is more of a toss-up after recent progress from Republicans in key toss-up states like Georgia, Pennsylvania, Nevada, and Arizona.
Don’t forget to get out and vote!
Week in Review:
The markets had more of an uneventful start to the week, however higher than expected inflation readings from Europe and additional Covid concerns in China had investors playing defensive on the day and led US indices lower. Oil and the energy markets made their way back to headlines after President Biden threatened energy companies with a windfall tax on profits as he says they are “making record-setting profits even as they refuse to help lower prices at the pump.” The more value-oriented Dow fell 0.39% while the S&P 500 lost 0.75%. However, the Dow closed out the month of October with a 13.95% gain for its best month since 1976.
Premarket futures were off to a solid start Tuesday and stocks opened in the green. Then the DOL reported job openings that were 10.7 million, almost one million above what was expected, leading to a reversal in stocks. Markets have looked for a reason to support a Fed decision to pause rate hikes, but this report did the opposite as it reflects a still very tight labor market. Covid concerns in China continued, but there has been increased speculation the government is looking at ways to reopen and move on from its zero Covid policy. Stocks ultimately closed lower with value again outperforming growth as the NADAQ fell 0.89% while the Dow declined 0.24%.
Earnings rolled in overnight Tuesday into Wednesday with very mixed results, including cautious guidance, but comments from the largest container shipper in the world caught attention after the CEO of Maersk warned of “dark clouds on the horizon.” All eyes were on the Fed, which raised rates 75 basis points as expected, and introduced new verbiage in its statement on future increases, but the press conference continued to be hawkish as the Fed continues to fight inflation, leading markets lower and bond yields higher.
Stocks continued selloff mode to start the day Thursday, but it was also because of another day of mostly disappointing earnings reports. In other central bank news, the Bank of England raised policy rates 75 bps as expected, with dovish commentary, while the European Central Bank gave more hawkish comments that rates still need to rise significantly. Stocks traded lower, but off the worst levels, with the S&P 500 down 1.06%.
It was a volatile pre-market on Friday as investors digested the employment report that was solid at the headline level, with more job gains than expected, but more of a mixed report with the unemployment rate ticked higher as more people became unemployed. Stocks initially fell sharply while bond yields rose, but then by the open stocks moved higher while bond yields leveled out over the sense the labor market may be beginning to weaken. By the end of the trading session, the S&P 500 moved higher by 1.36%.
It was another volatile week in the markets for both fixed income and equities, as well as commodities. Oil rose over 5% for the week in anticipation of the price cap on Russian oil, despite worries of Covid lockdowns in China reducing demand. In fixed income trading, bond yields moved higher, particularly in the middle of the curve with the 2-year Treasury yield rising to 4.65% from 4.32% while the 10-year yield moved 15 bps higher to 4.16%. It was a large underperformance of growth stocks, especially tech, in the equity markets as value outperformed. The major indices finished as follows: Dow -1.40%, Russell 2000 -2.55%, S&P 500 -3.35%, and NASDAQ -5.65%.
Recent Economic Data
- The PMI manufacturing index for October was 50.4 versus the 49.9 expected, down from 52.0 last month, indicating just a slight improvement in manufacturing conditions in the month. There was further growth in production, however firms noted a decline in new orders. Supply chains improving led to the first decrease in backlogs since the pandemic began. The lower demand seen has led to the slowest increase in employment in two years, but on the positive side is helping bring down cost pressures.
- The ISM manufacturing index was 50.2 for October, down from 50.9 in September but slightly above the 50.0 reading expected and the lowest since May 2020 (which reflects breakeven – anything above 50 reflects expanding conditions while a number below 50 reflects contracting conditions/activity). New orders declined again, with a reading of 49.2, while production picked up. Prices were actually in contraction territory at 46.6 while employment was unchanged at 50. Very similar results between the PMI and ISM surveys, reflecting declining orders, which is helping production pick up and leading to lower price pressures.
- Construction spending rose 0.2% in September, much better than the 0.6% decline expected and follows a 0.6% decline from August. Construction on residential projects, which has seen very large declines over the past two months, was flat in September compared to August, but still up 12.6% from a year ago (recall from the GDP report, residential investment declined a sharp 26.4% in third quarter). Nonresidential spending has seen declines as well, but not nearly as bad, and increased 0.5% in September and is 9.2% higher from a year ago.
- For the month of October, 14.9 million vehicles (on an annualized pace) were sold, well above the expectations of a 14.2 million pace, and increasing 10% from September’s 13.6 million pace. The shortages of semiconductors that go into vehicles continues to hinder the production of new vehicles and new vehicle sales.
- The Bureau of Labor Statistic’s productivity and costs data report, an important one for longer-term economic growth, showed worker productivity in the U.S. increased 0.3% in the third quarter (all numbers are seasonally adjusted annual rates). The slight improvement was due to a 2.8% increase in output, however hours worked increased 2.4%. However, when compared to a year ago, productivity has decreased 1.4%, reflecting a 1.9% increase in output but offset by a 3.4% increase in hours worked. The year-over-year decline is the third consecutive, the longest declining streak since 1982, also the last time inflation was running as high as it is now. Unit labor costs increased 3.5% in the quarter, driven by a 3.8% increase in labor costs and offset by a 0.3% increase in productivity. This measure is up 6.1% over the past year. Worker productivity was best in nondurable manufacturing, rising 4.0%, which was more than offset by a 4.3% decline in durable manufacturing.
- The trade deficit for the month of September was $73.3 billion, up $7.6 billion from the level in August. The rise in the trade deficit was due to a 1.5% increase in imports, or $4.8 billion more than August to $331.3 billion, while exports fell 1.1%, or $2.8 billion, to $258.0 billion. Year-to-date, the deficit has increased 20.2%, or $125.6 billion, due to a 20.2% increase in exports and a 20.2% increase in imports.
- Freddie Mac’s weekly mortgage survey showed the average prime 30-year mortgage rate was 6.95%, including 0.8 points, falling from the high water mark of 7.08% the week prior.
- The September job openings and labor turnover survey showed there were 10.717 million job openings on the last day of the month. Openings were expected to decline to just under 10 million, so this was a large beat to the upside. The survey also showed there were 5.7 million job separations, down 370k, with 4.1 million quits, little changed from prior months, and layoffs of 1.3 million, declining in the month. Stocks fell immediately after the report because the report indicated the job market remains very tight and still shows no signs of easing, leading to higher interest rate concerns.
- The ADP employment report said 239,000 payrolls were added in October, above the expectations of 200,000 and follows a 208,000 increase in September. The ADP chief economist said of the report hiring was not broad-based and goods producing sectors are actually pulling back hiring and the demand destruction from the Fed’s higher rates is only affecting certain sectors so far.
- For the week ended October 29, there were 217,000 claims for unemployment benefits, a decrease of 1,000 from the prior week with the four-week average unchanged at 218,000. The number of continuing claims was 1.485 million, up 47,000 from the prior week and up 102,000 from two weeks ago, a large increase over a short period. The four-week average is 1.417 million.
- Establishment survey data from the DOL’s October labor report showed employment increased by 261,000 in the month, higher than the 210,000 expected. In addition, revisions for August and September resulted in another 29,000 jobs. Solid gains were seen in health care, professional/technical services, manufacturing, social work, whole trade, and leisure and hospitality with no industry seeing meaningful declines in employment. The establishment survey also showed wages increased 0.4% in the month, also above expectations, with the increase from a year ago at 4.7%, still above a normal trend level, but down from 5.0% in September. Turning to the household survey, those in the labor force declined 22k bringing the labor force participation rate lower to 62.2%, down from 62.3% and down from the post-Covid high of 62.4%, and more than one percent below pre-covid levels of 63.4%. The number of people employed declined 328,000, bringing the total number back below pre-covid levels. The number unemployed increased 306,000, erasing all of September’s decline and bringing the total number back above 6 million to 6.059 million. This caused the unemployment rate to increase to 3.7% from a covid low of 3.5%. The underemployment rate, the U-6 rate, increased to 6.8% from 6.7%. It was a very mixed report, with solid headline numbers, but digging deeper may suggest the start to a weakening labor market. We have to remember the labor market has been strong and one report will not make a trend.
- Apple warned that shipments of its higher-end iPhone models, like the iPhone 14 Pro and iPhone 14 Pro Max, would be lower than what it previously expected due to Covid restrictions in China at one of its major suppliers. Apple said its largest assembly site, Foxconn in the city of Zhengzhou, is currently operating but at a reduced capacity, which will affect the important holiday shopping season where customers may experience longer wait times to receive the new phones.
- Johnson & Johnson announced it will acquire the cardiovascular company, who makes cardiac pumps, Abiomed for $380/share in cash. This is a 52% premium to the stock’s closing price prior to the announcement of the deal and values the deal at $16.6 billion. The deal is expected to close at by the end of the first quarter 2023.
- Shares of Apellis fell last week after announcing the FDA review period for its lead candidate drug pegcetacoplan will be extended due to its plans to submit long-term data. It was given priority review in July and had an assigned date of Nov 26 for the date of action for the new drug application.
- Multiple reports have said Walgreen’s primary care unit, Village Practice Management, is nearing a deal to combine with Summit Health, owner of medical practices and urgent care centers and the parent company of CityMD urgent care centers. The transaction would be valued at about $9 billion, with health insurer Cigna expected to be an investor in the combined company.
- Early in the week, after discovering a single positive Covid case from a guest at Shanghai’s Disneyland, officials closed down the park and prevented guests from leaving unless they were tested first, among other requirements. There were also reported cases in the major manufacturing city of Zhengzhou, which is the location of the main Foxconn factory, Apple’s largest iPhone manufacturer. Sources were telling Reuters that production of the new iPhone 14 could drop 30% due to tightening Covid restrictions in the area. At the same time, there has been increased speculation on social media that China is looking to phase out its Zero Covid policy, leading to a large move higher in Chinese stocks. Its Foreign Ministry pushed back on the speculation and later in the week the National Health Commission said China must “unwaveringly” stick with its zero Covid policy that it has had in place.
- Reports say U.S. inspectors completed audits of Chinese companies about two weeks ahead of schedule, helping Chinese stocks move higher. Recall, it was recent where Chinese regulators allowed U.S. auditors full access to Chinese company’s financials, with the discretion to inspect, alleviating concerns of delisting Chinese stocks from U.S. exchanges.
- In a speech early last week, President Biden threatened oil companies and oil producers with a windfall tax on oil companies’ profits as he says oil companies are “making record-setting profits even as they refuse to help lower prices at the pump.” However, a measure like this would need to pass Congress and there is no indication it will have enough votes to pass the Senate.
- There has been increasing political tensions around the globe; Saudi Arabia went on high alert after warning of an imminent attack by Iran, North Korea fired 10 ballistic missiles into the western sea after U.S. and South Korea ended a high-profile military exercise, and Chinese military vessels entered Japan’s territorial waters for the fourth time this year.
- Central bank news:
- The Royal Bank of Australia raised its benchmark interest rates by 25 basis points to 2.85%. It was a smaller increase than expected, but the central bank indicated more rate hikes to come as inflation remains at 30 year highs.
- The Bank of England raised its policy rate 75 basis points to 3.0% (its first 75 bps hike since 1989), with the policy committee sounding much more cautious than global central banks. It said the peak/terminal rate is lower than what is priced into financial markets, while saying a more gradated approach is warranted to avoid overtightening policy. It says if rates stay this high it expects a two year recession. It was a 7-2 vote with the dissenters voting for a 50 bps hike and the other for a 25 bps hike.
- European Central Bank policymaker Nagel said last week the ECB has a long way to go on rate increases, it should continue to raise interest rates further, while saying the central bank should begin reducing its balance sheet by selling bonds at the start of 2023. ECB President Lagarde later reiterated these comments, while saying a recession will not be sufficient to bring down inflation back to its objective.
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The Week Ahead
The calendar lightens up from an economic and corporate earnings perspective, but there are still notable reports on both. Within the economic calendar, the highlight will be the consumer price index report on Thursday. Inflation is widely expected to have picked up in October with the consensus seeing a 0.7% monthly increase with core prices continuing to tick higher, expected to rise another 0.5% in the month. We will also see weekly jobless claims on Thursday and the mid-month read on consumer sentiment on Friday. On the earnings calendar, notable reports will come from Activision Blizzard on Monday; Disney, Occidental Petroleum, DuPont on Tuesday; D.R. Horton, Hanesbrands, Roblox on Wednesday; and Tapestry and Ralph Lauren on Thursday. With the November FOMC meeting past us, Fed policymakers will be able to make public comments again with many speeches on the calendar for this week. Finally, Midterm elections will take place Tuesday with citizens voting for who will control Congress for the next two years. Republicans are still favored to win the House, but the Senate is more of a tossup according to polling, with several key races in Pennsylvania, Arizona, Wisconsin, Nevada, North Carolina, and Georgia. Markets would most likely welcome this outcome as it would lead to a split Washington and more likelihood of a political gridlock which means less new legislation.