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The Wall Street/Fed Game of Chicken

Wall Street is getting bullish … will the Fed finally play nice? … the mismatch between rate expectations for December 2023 … the headwinds for earnings

A week from Wednesday brings the conclusion of a critical Fed policy meeting.First, we’ll get the Fed’s decision as to the size of its upcoming interest rate hike. Wall Street is all-but-certain it will be only 25 basis points (97.7% odds as of Monday morning).Second, and perhaps more important, we’ll get clues from Federal Reserve Chairman Jerome Powell about the Fed’s likely policy path as we head deeper into 2023.The market is in an interesting place coming into this meeting.There’s a growing sense of bullishness in the air. Driving this growing enthusiasm are a slew of recent economic reports all pointing toward cooling inflation, a slowing economy, yet a labor market that isn’t collapsing.In short, it’s a Goldilocks environment.Wall Street is so excited that the S&P is on the verge of pushing north through its 2022 down-sloping trend-line…

Chart showing the S&P over the last year with its downward trendline - the S&P is about to push north through this line
Source: StockCharts.com

But this blue-sky scenario has two headwinds: a Fed that disappointed bulls for all of 2022 and continues to skew hawkish, and the potential for weaker-than-expected earnings throughout most of 2023.

The ongoing game of poker between Wall Street and the Fed

As we’ve been tracking here in the Digest, whether you want to call it a game of poker, chicken, or “who will blink first,” there’s tension between Wall Street and the Fed.The Fed has consistently said rates are headed higher (above 5%) and will remain elevated for “some while.”Here’s Bloomberg from last Thursday, summarizing this position:

Federal Reserve Bank of New York President John Williams said officials have not completed their aggressive tightening campaign to reduce stubborn price pressures…Policymakers see rates rising to 5.1% by the end of this year, according to median quarterly projections released by the Fed last month.Officials say they expect to hold rates at restrictive levels for some time to allow their actions to travel throughout the economy. 

Okay, well, a 5.1% interest rate hurts, that’s for sure.But 5.1% for one month is far different than 5.1% for, say, six months, or nine months.The longer the Fed holds rates above 5%, the greater the economic pain…which hurts corporate earnings…which hurts stocks prices.So, the devil is in the details. How long is “some time” for the Fed holding rates at such restrictive levels?Here’s Reuters from mid-December:

San Francisco Federal Reserve Bank President Mary Daly on Friday said it’s a “reasonable” to think that once the Fed policy rate gets to its peak, it will stay there for nearly a year, and added she’s prepared to keep it there longer if needed.“Everybody has rates holding for ’23,” Daly said in a virtual event at the American Enterprise Institute, referring to interest-rate projections from all 19 Fed policymakers published earlier this week, when they also signaled they will likely need to lift the policy rate to 5.1% in coming months. 

By my count, 11 months from today equals roughly mid-December 2023.Hey – it turns out there’s a Fed policy meeting in mid-December 2023! And what do most traders expect will be the Fed’s target rate range at that time?Just 4.25% – 4.50%.But didn’t we just learn that the Fed plans to hike rates to 5.1%, then Daly said that “Everybody has rates holding for ’23”?She did…and there’s your game of chicken.

Despite the Fed’s rhetoric, Wall Street does not seem to believe them

Here’s MarketWatch, citing the path forward that many on Wall Street believe is in the cards:

The ABA forecasts inflation to slow to 2.8% in 2023 and 2.2% in 2024 from an average 6.4% rate in the prior year, based on the consumer price index.That would put the rate of inflation close to the Fed’s 2% goal a bit faster than the central bank has forecast…Under that scenario, the Fed would actually start cutting interest rates before the end of 2023, the ABA economists predicted, and help spur a modest recovery by 2024.

Wall Street is now increasingly convinced this is how things will play out.In fact, take a guess: What percentage of traders believe that rates will be at the Fed’s highlighted 5.1% terminal rate come December 2023?Ready?Just 2.2%.Now, Wall Street might be exactly right. This might be one gigantic Fed poker face.But if Wall Street is wrong (which it was for the entirety of 2022), then we’re in for another stock market tantrum when the Fed does what it’s saying it will do.Given all this, we will be looking for clues next Wednesday.Specifically, we’ll be listening for any language that resembles the minutes from the December policy meeting. That would give us pause before betting against the Fed’s resolve.If you forgot this language, here’s Bloomberg to remind you:

Federal Reserve officials last month affirmed their resolve to bring down inflation and, in an unusually blunt warning to investors, cautioned against underestimating their will to keep interest rates high for some time.Going into the meeting, markets were pricing in rate cuts in the second half of 2023. The tone of the minutes of the Federal Open Market Committee’s Dec. 13-14 gathering suggested frustration that this was undermining the central bank’s efforts to bring price pressures under control.Fed officials noted that “an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the committee’s reaction function, would complicate the committee’s effort to restore price stability,” according to the minutes.

All ears should on Powell next Wednesday.We’ll keep you updated.

The second headwind impacting Wall Street’s recent bullishness is what’s likely to be a challenging 2023 for earnings

Even if the Fed surprised everyone and stopped hiking interest rates next week, the U.S. economy still has six-to-eight months of economic tightening ahead of it.This six-to-eight-months represents the estimated leg time between a Fed rate hike and when the economy feels the sting of that rate hike.So, conditions today reflect the Fed’s hikes that took place before roughly May through July.Consider all the rate hikes that have happened since then…June – 0.75%… July – 0.75%… September – 0.75%… November – 0.75%… December – 0.50%…Based on this, here’s MarketWatch with a less-rosy forecast of what’s coming:

The U.S. is going to experience “zero” growth in 2023 and teeter on the verge of recession, economists say, as a result of rising interest rates orchestrated by the Federal Reserve to subdue high inflation.Top economists at the American Bankers Association say the resulting slowdown is likely to trigger a sharp increase in layoffs and push the unemployment rate close to 5% within the next two years.A rapid rise in wages over the past year is also expected to peter out.

Zero economic growth, climbing unemployment, and a reversal in wage gains does not bode well for corporate earnings.

But there’s another problem on this earnings front…

We’re at the tail end of the 2020 stimulus boom, which artificially inflated earnings data.Here’s Morgan Stanley with those details:

[Investors] seem to be overlooking how the largest stimulus program in U.S. history, precipitated by the pandemic, has kept current profit margins and demand levels running above long-term trends. For example:

  • The operating margin of the S&P 500 Index, at 11.6%, is still near the all-time high of 13.1% reached in late 2021—notably above pre-pandemic levels of 10.2% and the rolling 10-year average of 9.4%.
  • 2022 nominal revenues for S&P 500 companies were 8% above the 10-year trend.
  • Last year’s real, or inflation-adjusted, consumption was about 7% above its long-run trend.

Despite these above-average figures – which, if they return to normal would mean an earnings contraction – the consensus forecast for 2023 S&P earnings growth is nearly 4%.So, before, Wall Street was playing chicken with the Fed.But in this case, Wall Street is playing chicken with the U.S. economy and earnings…

“We think your rumblings about a recession are just a bluff. You’re going to grow this year, and tack on 4% gains to corporate America’s earnings!”

Morgan Stanely doesn’t share this view.Back to its recent report:

Morgan Stanley’s Global Investment Committee thinks such [S&P 2023 earnings] projections are overly optimistic and put too much faith in corporate resilience while lacking historical perspective.Importantly, considering that margins and demand levels remain so far above historical trends, we are likely to see performance revert to long-run average levels.This alone — to say nothing of a potential economic recession this year — could bring a meaningful correction in corporate results and asset prices.

All things considered, Wall Street appears pretty sure of itself, despite a considerable number of reasons for caution

So, we echo the same position we’ve held for months…We believe that today’s prices are likely to make investors solid returns when viewed from a long-term multi-year perspective.But in the near-term, we believe the market could have one more leg down in the next few months based on a more hawkish Fed or disappointing earnings.We’ll be looking for clues come next Wednesday.Have a good evening,

Jeff Remsburg


Article printed from InvestorPlace Media, https://investorplace.com/2023/01/the-wall-street-fed-game-of-chicken/.

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