It feels a bit like déjà vu entering the fourth quarter. The stock market has fallen sharply since mid-August and the R-word, recession, is at the top of the mind of most investors. The setup was similar in late June as we entered the third quarter.
Dour investor, business and consumer sentiment continues to be driven by uncertainty. The key risks to the market are still inflation and actions by the Federal Reserve Board (the Fed). But geopolitical risks have risen. The silver lining in the months ahead might be that seasonality is in our favor. The strongest six-month period of the year usually starts in November, and that performance is even better in mid-term election years. Couple that with a low unemployment rate, a steady consumer, solid corporate balance sheets, and valuations that have reset lower, there is an opportunity for a Santa Claus rally.
That said, with the Fed in the driver’s seat, markets continue to live and die by data releases, especially those related to jobs, inflation and the Fed. Near-term, the road is likely to be rocky with the potential for more downside, but the end of the quarter could make up for that.
Fed in the driver’s seat
Determining where markets are headed this year has proven particularly difficult as signals from various indicators (economic, fundamental, technical, etc.), not the least of which is Fed policy, have shifted quickly throughout the year.
By late July investors were seemingly convinced a soft landing by the Fed (where rates rise and the economy slows, without being pushed into a recession) was in the cards. Solid jobs data and a cooling of CPI inflation were key drivers of this thinking. Then the Fed reminded investors that they were in control.
Hope turned into anxiety in late August at a gathering in Jackson Hole where Fed Chairman Powell delivered a short and stern message, doubling down on his commitment to return inflation to much lower levels by rapidly raising interest rates. A hotter-than-hoped for inflation reading in September (for the month of August) set the Fed up to fulfill Powell’s promise. And that they did. At the Fed’s September meeting an aggressive path forward for interest rates was outlined, including the potential for an additional 125 basis points increase (or a 1.25% percentage point change) in 2022, putting the Fed funds rate at 4.4% at the end of the year. Given the impact this has on the cost of borrowing for households and businesses, the reaction has been negative.
The S&P 500 corrected lower by 10% from mid-August through late September. Meanwhile, the 2-year Treasury rate notched its highest level since 2007 while the key 10-year rate hovers at 11-year highs. It quickly began to feel a gloomy future was coming.
The key for the fourth quarter will be where interest rates go from here. Despite the Fed’s guidance on rates, investors know the Fed has a poor track record of making projections. This time last year the Fed expected the Fed funds rate to be 0.3% at the end of 2022 (that compares to the current 4.4% projection). As the fourth quarter unfolds, investors will grapple with when the Fed can pause or end this cycle of raising rates. This is a major overhang for markets. Currently the market doesn’t anticipate a pause until rates reach above 4.6%.
History shows that the Fed is often done hiking once its policy rate climbs above the 10-year Treasury yield. With the 10-year yield at 3.7% as of Friday, September 23, 2022, we may not have far to go. That said, the real driver of Fed action in the coming months will likely be inflation. A cooling of inflation could put the hope of a soft landing back on the table.
Inflation – the most important indicator
Inflation has been more stubborn than anyone would like. A combination of both supply and demand issues have driven inflation rates to the highest levels in 41 years. August CPI increased 8.3% year-over-year, well above the long-run rate of 3.3% going back to 1980. While the concern with that mid-September release was that inflation isn’t cooling as quickly as liked, investors seem to have lost sight of the fact that the peak in inflation was logged in June and the trend is still in the right direction.
Admittedly, the downward trend needs to continue for longer, and steeper declines would be welcome. The good news is certain inflationary drivers are cooling and consumer expectations about future inflation are retreating. Unfortunately, that data has been ignored as stickier parts of inflation take center stage. Shelter prices, which tend to take longer to show up in inflation data and then stay around for longer, increased 6.2% in August, the highest increase since 1990. The worry is that this could drag on inflation for many months as shelter accounts for about a third of CPI. That would make it difficult for the Fed to slow or pause its aggressive interest rate policy.
Digging deeper, the Zillow Home Value Index shows prices have started to drop dramatically in the last two months. The 0.3% decline in prices in August from the month prior was the steepest drop since 2011. Prices are still 14.1% higher year-over-year, but that growth rate has decelerated in the past few months. A similar trend is occurring in existing home prices. The year-over-year increase peaked in May at 25% but has since slid to 7.7% in August.
Home prices have been primarily demand-driven and the Fed has taken direct aim at cooling that market to help the inflation picture. Commodity prices have come off highs as global recession worries and demand concerns mounted over the summer. What’s more is that many of the pandemic-driven, supply side issues are starting to show signs of relief. Shipping costs, transportation costs, container costs, ISM service pricing, used car pricing, and other inputs are all falling or coming off highs. As the fourth quarter progresses, these changes should show up in lower inflation data.
The consumer has made note of some of these changes and is sharply adjusting their expectations lower for prices over the next twelve months, according to a recent New York Fed survey. The decline in gas prices has played a key role in the reduction in inflation expectations for consumers. The national average gas price has dropped from $5 a gallon in mid-June to $3.70 a gallon now, a 26% reduction in just over 3 months. While inflation overall a year from now is still projected to be higher than the Fed’s 2% target, the steady decline in expectations is a very good trend. When consumers believe prices will continue to go higher, that can turn into a self-fulfilling prophecy, which is what the Fed wants to avoid. So long as gasoline prices don’t jump significantly, the consumer continues to see near-term inflation moderating, and the trend for supply-side inflation inputs continues to move lower, the Fed may find reason to pause rate hikes or at the very least dial back their rhetoric.
Inflation carries a heavier weight in market direction in the fourth quarter than many other economic data points as the Fed has made clear that this is the driver of their policy.
Earnings worries don’t matter
There is a lot of talk about how earnings estimates for corporations are too high for the third quarter and beyond. Just like last quarter, CFOs have every reason to kitchen-sink their outlooks. The strength of the dollar, global slowdown, tightening financial conditions, and geopolitical uncertainty are all legitimate reasons for earnings estimates to be lowered, especially when operating margins are elevated.
But would cutting forecasts even matter? Lower guidance may already be in the process of getting priced in. If that is the case, the impact on the overall market will be less significant when it happens (individual stocks could still have outsized reactions). If things turn out better-than-expected, the market reaction could also be muted. The reason: There are bigger factors at play. Just like last earnings season, the market will be more reactive to, and more significantly impacted by, the Fed and inflation in the near-term.
That said, we can learn a lot about various end markets and the economy from corporate earnings. Earnings season should not be ignored. Just don’t expect results to drive market action this quarter.
The bottom line
Don’t be discouraged by this year’s market drop. There are reasons to be hopeful as we finish off the year. The euphoria that marked 2021 has given way to fear, and investors are now positioned defensively ahead of what is usually a great time to own stocks – which are cheap by many valuation measures, by the way. Meanwhile, the consumer remains resilient, particularly now with falling gas prices, and the jobs market is robust with more folks coming back into the labor force. Corporate balance sheets also remain healthy.
Amid such dismal investor sentiment, bearish positioning, and fear running amuck, the bar might be low enough to set the stage for a strong rally to finish off a tumultuous 2022.
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Lindsey Bell, Ally’s chief markets & money strategist, is an award-winning investment professional with a passion for personal finance and more than 17 years of Wall Street experience. Bell’s unique ability to connect the dots between data and real life and craft bite-sized money ideas that people can use and apply stems from her deep background as an analyst, researcher and portfolio manager at organizations including J.P. Morgan and Deutsche Bank. She is known for demonstrating why and how an understanding of all things money improves a person’s finances and overall well-being. An ongoing CNBC contributor, Bell empowers consumers and investors across all walks of life and frequently shares her insights with the Wall Street Journal, Barron’s, Kiplinger’s, Forbes and Business Insider. She also serves on the board of Better Investing, a non-profit focused on investment education.
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