Investors Pan the Fed’s Hawkish Tone

The slump for equities continued last week, as Federal Reserve Chairman Jerome Powell’s hawkish comments when announcing the latest rate hike were viewed as a sign the Fed was going to go too far in its quest to tame inflation. The size of the hike — 75 basis points — was widely viewed as a foregone conclusion. However, the Chairman’s insistence that backward-looking measures of inflation will need to show decisive improvement before the Fed softens its stance on rate hikes is what sent investors heading for the exits.

Based on the data we’ve seen during the past several months, we view the Federal Open Market Committee’s (FOMC) position as unwarranted. As we noted in last week’s commentary, there has been marked progress in the vast majority of forward-looking indicators ranging from replenished inventories to the clearing of delivery bottlenecks and an easing of price pressures on both the wholesale and retail levels. Even housing, which had defied gravity through the first half of the year, has dramatically slowed. As if to preempt this argument, Powell acknowledged the strides made on forward-looking data but then homed in on rearview measures such as a still-tight job market and slower-than-hoped improvements in the core Personal Consumption Expenditures (PCE) Index and the Consumer Price Index (CPI). Even on the inflation expectations front, which the Fed has long cited as a harbinger for inflation becoming embedded, Powell acknowledged that surveys and credit spreads alike point to well-anchored expectations.

Perhaps the fear that consumers flush with cash and working in a rising wage environment will begin to buy ahead of price hikes is what is leading the Fed to its stubbornly hawkish stance in the face of improving data. But with the economy teetering on the brink of a mild recession, which will put further downward pressure on demand, we believe the board of governors is misreading the situation. Households have spent the past 13 years following the Great Financial Crisis rebuilding their balance sheets. As a result, the ratio of monthly expenses to disposable personal income is now at 42-year lows. Despite this strong financial position, consumers have been reluctant buyers for months as they seek to wait out what they believe are temporary price spikes. Likewise, the most recent data from the University of Michigan Sentiment Survey highlights that consumers expect wage gains to be modest in the year ahead, which is likely to translate into conservative spending habits in the coming year.

While we have been frustrated by the Fed’s willingness to favor backward-looking data over continuing improvement on forward-looking measures, we are encouraged that Powell acknowledged improving trends in everything from housing to cost pressures for manufacturers. We believe this acknowledgement provides the FOMC an opportunity to press pause in this rate tightening cycle quickly once CPI or Core PCE show improvements.

Wall Street wrap

As the Fed remained fixated on backward-looking inflation measures, data out last week pointed to growing momentum in the decline of price pressures.

Housing continues to cool: Existing home sales fell for the seventh month in a row, according to the latest report from the National Association of Realtors: They are now down 26 percent from recent highs and off 19.9 percent, year-over-year. Likewise, home prices have come down with the median sales price now at $389,500 compared to a record high of $413,800 recorded in June. While the data reflects some seasonality, the rapid rise in mortgage rates this year will likely continue to weigh on prices as homeowners with low-interest fixed rate mortgages opt to stay put instead of trading up and taking out loans with interest rates now topping 6 percent.

According to data out last week from the National Association of Home Builders (NAHB), the chill in the housing market is also being felt by builders. The latest sentiment reading in its Home Builders Index fell to 46 (readings of 50 or above indicate expansion). Contrast that to the beginning of the year when the optimistic builders pushed the reading to 84. Since then, sentiment has fallen each month, marking the longest streak of consecutive declines on record. The pessimism has spurred more than half of builders surveyed to offer buyers incentives such as mortgage rate buydowns, free upgrades and price reductions. Robert Dietz, chief economist for the organization, noted that the housing recession is showing no signs of easing.

While much has been made that higher interest rates are making home ownership less affordable for apartment dwellers, which could cause rents to remain high, the NAHB survey hinted at a coming uptick in the supply of multi-family units. The latest report showed starts for multi-family properties rose to 640,000 units, the highest level since 1986. Additional units should help ease the supply and demand imbalance and lead to softening rents.

More signs of a stalling economy: The Conference Board’s latest Leading Economic Index (LEI) registered declines for the sixth consecutive month and is now down in seven of the past eight readings. The August reading dropped 0.3 percent from July and now is down 2.7 percent since February. On a year-over-year basis, the measure is off 1 percent — it’s worth noting that every other time it has dropped to its current level, a recession has followed. The ongoing contraction of the economy along with supply levels that are approaching pre-COVID levels should continue to take the wind out of the sails of rising prices.

Flat growth and easing costs: The latest Purchasing Manufacturers Index readings released by S&P Global paints a picture of an economy treading water. Despite improvements in the Services sector and a modest uptick in manufacturing, preliminary readings for September for the composite were at 49.3 (readings above 50 indicate expansion). The overall trend of readings has improved during the past three months; however, the lackluster reading still suggests demand remains subdued and is unlikely to support continued rising prices. Indeed, prices charged to customers dropped in the most recent survey as cost increases for businesses slowed to the lowest level since January 2021.

A word on investor sentiment: Concerns that the Federal Reserve is driving the economy toward recession have taken a significant toll on investor sentiment. The latest reading of the American Association of Individual Investors shows that bullish sentiment among retail investors slid 8.4 percentage points to just 17.7 percent, while bearish sentiment vaulted to 60.9 percent — an increase of 14.9 percent from the previous week. This marks the 10th time this year where bullish sentiment has dropped below 20 and only the fourth time in the history of the survey that bearish sentiment has registered above 60. Historically, extreme readings (bullish or bearish) on the AAII survey have been a reliable predictor of future market performance, although not in the way individual investors probably expect. All 16 times in the past when investor bullishness was below 17.7 percent, the market produced positive returns over the subsequent 12 months.   

The week ahead

• Monday: The Chicago Federal Reserve Bank releases its national activity index. The report provides a look at economic activity across the country as well as related inflationary pressures. This report, along with Tuesday’s release of real-time GDP estimate from the Federal Reserve Bank of Atlanta will provide further insights as to whether the U.S. economy has already entered a recession.
• Tuesday: The latest real-time estimate of GDP for the third quarter will be released by the Federal Reserve Bank of Atlanta. Estimates have been trending sharply lower of late and we will be watching for changes in the trajectory of the latest data.
  
  The Conference Board’s Consumer Confidence report will come out in the morning. While gas prices have eased in recent months, we expect inflation concerns will continue to act as a drag on confidence, we will be on the lookout for any changes in trends as well as the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find compared to those who report challenges finding work. The measure has weakened by 10.5 percentage points since March, which may be pointing to a softening job market.
• Friday: The latest Personal Consumption Expenditures (PCE) price index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions. We will be watching for evidence that recent trends in prices are beginning to have an increased impact on the rate of decline of this important inflationary measure.

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