Recent momentum in the equity market has once again stalled following another round of hawkish comments from Federal Reserve Chair Jerome Powell. Market participants had hoped to see signs of a pivot towards softer policy coming out of the November meeting. Instead, they were hit with a stark reminder that the labor market remains far too tight and inflation far too high for the Fed to call mission accomplished. Though the pace of future rate hikes may slow, estimates of the terminal Fed Funds rate continue to shift higher. With more hikes on the way, odds of a recession in 2023 remain elevated.
Despite 375 bps of tightening over the last eight months, the labor market remains exceptionally robust. In the last week, we saw job openings tick higher, jobless claims move lower, labor force participation decline, and payrolls come in higher than expected. These are all signs that wage pressures are likely to persist. Inflation has already begun to migrate from goods to services on the back of higher wages and this recent data offers no relief. Inflation in services can be dangerously sticky. Thus, until wage growth is tamped down, the Fed cannot afford to take its foot off the brake.
To date, the economy has held up reasonably well, but cracks are starting to show. Big fluctuations in imports and exports have made GDP prints unusually noisy through the first three quarters of 2022. Real GDP grew at 2.6% in Q3, but the growth came almost entirely from a sharp reduction in imports. Consumer spending made up the balance of growth, but the pace has begun to slow as the year has progressed. On the other side of the ledger, housing is now showing as a major drag on economic growth. The sharp rise in mortgage rates has led to a meaningful reduction in activity across the sector. Trade will eventually level off. When it does, we will be left with economic drivers that are looking increasingly vulnerable. Much depends on the durability of the consumer. Covid savings are quickly evaporating, and persistent inflation and higher borrowing costs could eventually spell trouble.
Earnings have also held up better than expected this year. We are well into the Q3 earnings season, and stocks have surprised to the upside on sales and earnings in the aggregate. However, strength in the energy sector is masking some pain, and many of the tech darlings of the last decade are starting to show signs of stress. Earnings estimates for 2023 are now beginning to roll over, and we believe there is likely more downward adjustment to come. The market has not fully priced in an earnings adjustment consistent with a recessionary environment. We believe this remains a key risk for the market.
We continue to emphasize the importance of sticking to the kinds of companies that have worked this year. Companies with a greater portion of their value tied to current earnings continue to outperform those valued solely on future growth potential. This has been true through the downturn and through the series of broader market rally attempts that we have seen. Many dividend-paying companies continue to sit at the forefront of this value-oriented leadership.
Preston May, CBE®
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