A Fed pivot? Tread carefully.
After a tumultuous September, investors had something to cheer about in October. But this is not the time to get carried away with the idea of a coming pivot in U.S. Federal Reserve policy, says Matt Orton, CFA, Chief Market Strategist at Raymond James Investment Management.
So Orton says it’s too early to change his playbook and still favors maintaining a core defensive bias, leaning into dividend growth, profitability, and growth at a reasonable price (GARP).
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A Fed pivot? Tread carefully.
Oct. 31, 2022
After a terrible September, the price action in October has felt a lot
better, but this is not the time to get carried away about the idea of
a coming pivot in U.S. Federal Reserve policy, said Matt Orton, CFA,
Chief Market Strategist at Raymond James Investment Management.
“It’s encouraging to see that the market can move higher when it’s
supposed to,” he said, “but the rally is getting a little long in the tooth
and is getting to look like it did over the summer. The key thing to bear
in mind is what killed the rally over the summer was the Fed, so what
happens on Wednesday is going to be critical in the very short term
for driving the direction of the markets.”
Coming into this week, the S&P 500 Index has gained 8.9% in October
with breadth and market internals continuing to improve. In fact,
the “market of stocks” has done even better than the broad indices,
evidenced by the S&P 500® Equal Weight Index jumping 10.3% this
month. The relief rally was very well-telegraphed with oversold
conditions, washed-out positioning and sentiment as well as
favorable seasonals, but Orton said we’ve rapidly approached a key
inflection point for the coming weeks. “There are plenty of reasons
to expect that Oct. 12 was the low, but the weight of the evidence
continues to suggest that we’re not out of the woods just yet,” he said.
This week will be very important given a busy economic data calendar
– headlined by the Federal Open Market Committee (FOMC) interest
rate decision on Wednesday – as well as a continuation of earnings
season with about a third of the S&P 500 companies reporting. But
the recent price action is certainly encouraging, and Orton said that
cannot be ignored.
Global yields have finally moved started to move lower as developed
market 10-year yields revert to their means from cycle highs. While
the recent moves are but a blip given the magnitude of the recent
rise in global yields, Orton said it’s worth noting that a slowing of
global yields and the dollar are precursors for a stabilization in risk
assets. October is also the most common month to see bear-market
bottoms, and if we follow the typical pattern from October lows, Orton
said he would expect to see some consolidation over the coming
weeks followed a rally into the new year. But he said he still has some
concerns about challenges ahead. Rate volatility remains elevated,
and we haven’t seen financial conditions roll over in any meaningful
way. Since 1987, financial conditions tend to lead the equity market
and that hasn’t happened: the S&P 500 is far ahead of the retracement
in the Goldman Sachs Financial Conditions Index. Additionally, for
the stock market to move higher, mega-cap companies will need to
reclaim their respective 50-day daily moving averages to signal that
the fundamental backdrop is in fact improving.
Ultimately, however, the Fed controls the path higher or lower for
the market, Orton said. Treasuries have staged a decent rally since
a report that the Fed might soon slow the pace of tightening. Many
investors have been keen to interpret this as the policy “pivot” that
markets have been speculating about since early this summer. Orton
said slowing the pace of rate hikes doesn’t necessarily translate into
a lower terminal fed funds rate. But it does mark a deliberate change
in the Fed’s communication strategy. For the last six months, the
Fed has relentlessly tried to push interest rate expectations higher
and engineer a tightening of financial conditions. And it has worked.
Housing and manufacturing have slowed meaningfully, and there
is evidence that consumer spending is settling down and that wage
growth may start to normalize with demand finally softening. The Fed
also may be trying to settle down persistently elevated volatility in the
fixed income markets and prevent the rapid tightening of financial
conditions from taking on an endogenous dynamic (i.e., that negative
feedback loop we’ve discussed where an environment of tighter
financial conditions feeds upon itself). Whatever the exact reasons
for the change in communications, it’s too early to say that they will
lead to the easing of financial conditions that are necessary for a
sustainable rally. But we’re getting a preview of quickly markets will
react should there be a change to the terminal rate forecasts already
implied in the futures curve.
While increased market breadth is encouraging, financial conditions
aren’t necessarily telling the same story. The minimum requirement
for a trend reversal is a retracement of 38.2% of the bear market
decline, Orton said, and in past bear market bottoms we have seen
financial conditions reverse trend before or at the same time as
the equity market. In this case, equities are much further ahead of
financial conditions.
My biggest concern is that the market, like
over the summer, has gotten ahead of itself,”
Orton said.
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Why to maintain a core defensive bias
The improved breadth across the market is very encouraging and puts
us on much better footing than in June when the last bear market
rally took off, Orton said. Earnings season has provided opportunity
for increased dispersion, and correlation is declining among index
constituents: only 57% of S&P 500 companies are in bear market
territory compared to 75% in June. It’s common for stocks to base
and turn up ahead of the index, but Orton said escape velocity
can only be achieved if other factors also fall into place. Right now
that’s a decline in macroeconomic uncertainty, and that can only
be achieved with a reliable change in the Fed. We’ll hear from Fed
Chairman Jerome Powell on Wednesday, but Orton said he expects
Powell to be very conscientious about avoiding a reprise of the market
reaction to his initial suggestion of a future downshift at the July FOMC
meeting, which he had to correct with his hawkish August Jackson
Hole speech. As a result, Orton said he expects Powell to aim to keep
December pricing between 50 and 75 basis points – and for the data
to determine the outcome.
As a result, Orton said it’s too early to change his playbook. He said
he still favors maintaining a core defensive bias, leaning into dividend
growth, profitability, and growth at a reasonable price (GARP). The
recent rally also has been led by more defensive companies with
dividend growth making new highs relative to the S&P 500. He said
it’s worth noting that we’re seeing the strongest earnings momentum
in energy and defensive sectors like healthcare, and the weakest
in materials, information technology, and consumer discretionary.
Healthcare and energy remain the market leaders while industrials
and smaller-cap regional banks are making fresh new highs. Large-
cap healthcare remains Orton’s favorite sector as earnings remain
quite strong with more reports due this week. He said he also still likes
having exposure to small caps as a way to keep exposure to a market
rally: owning small caps helped portfolio performance over the past
two weeks with the Russell 2000® Index up nearly 10%. Valuations in
small caps remain attractive, he said, especially relative to large caps,
and flows remain anemic, which can provide tailwinds should that
change as investors inevitably chase performance. Flexibility remains
the key to success, and Orton said the increased dispersion we’re
witnessing is creating an increasing number of opportunities for stock
pickers.
Source: Bloomberg, as of 10/28/22
The rally in equities has run ahead of financial conditions
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Goldman Sachs U.S. Financial
Conditions Index
S&P 500 Index
January market peak
April recovery peak
High
in S&P 500 near trough
in financial conditions
The S&P 500 rally from the June
lows occured without a
comensurate reversal in financial
conditions, which led to lower
lows. Now equities have
recovered 20% of the bear
market decline while financial
conditions have only recovered
about 5%.
Financial conditions started to
reverse at the same time as
equity markets, but Orton said
equities are very far ahead and
we need to see financial
conditions move quickly lower in
order to have more confidence.
Financial
conditions index (higher
values = tighter conditions)
S&P 500 Index
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What to watch
It’s a busy week for earnings with nearly one third of the S&P
500 reporting, including companies in semiconductors; medical
technology; rental cars; pharmaceuticals and biotechnology; car
manufacturing; oil and gas; ride hailing; vacation rentals; pharmacies;
travel; health insurance; fast-food restaurants; online payments;
electric power; foods; and online sports betting.
The main event on the economic calendar will be the FOMC meeting
on Wednesday, but three other Group of 10 banks also will make
interest rate decisions. And it’s payrolls week, which Orton said will be
important for assessing any cooling in the labor market.
This week’s data releases
Monday
China Purchasing Manager Index; Eurozone inflation
and gross domestic product (GDP); Mexico GDP
Tuesday
U.S. construction spending, Institute for Supply
Management manufacturing Purchasing Managers’
Index, light vehicle sales; U.K. house prices; Australia
interest rate decision
Wednesday
U.S. Mortgage Bankers Association Weekly
Applications, ADP® National Employment Report™,
FOMC interest rate decision; Germany unemployment;
Japan central bank minutes; South Korea Consumer
Price Index; Eurozone manufacturing Purchasing
Managers’ Index
TM
Thursday
U.S. factory orders, durable foods, trade, initial jobless
claims, and Services ISM® Report on Business®; U.K.
interest rate decision; Caixin China General Services
Purchasing Managers Index; Eurozone unemployment
Friday
U.S. nonfarm payrolls and unemployment; Canada
unemployment; Eurozone Services Purchasing
Managers’ Index; Eurozone industrial producer price
index; France industrial production; Germany factory
orders
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Internals refer to quantitative market indicators that investment professionals monitor to spot trends and forecast movements within securities markets. A subset of technical
indicators, internals include a number of formulas and ratios, such as the number of stocks moving in the same direction as a larger trend, the ratio of securities with rising and
falling prices, the ratio of new highs to new lows, and price and volume indicators that are seen as indicators of overall market sentiment.
Oversold is a term used to describe a security believed to be trading at a level below its intrinsic or fair value.
The Goldman Sachs U.S. Financial Conditions Index is designed to track the weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with
weights that correspond to the direct impact of each variable on gross domestic product.
The daily moving average (DMA) is a calculation that takes the arithmetic mean of a given set of prices over the specific number of days in the past; for example, over the previous
15, 30, 100, or 200 days.
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lend their excess reserves to each other overnight.
An endogenous variable, also known as a dependent variable, is a variable in a statistical model that is influenced, changed, or determined by its relationship with other variables
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Hawkish, dovish, and centrist are terms used to describe the monetary policy preferences of central bankers and others. Hawks prioritize controlling inflation and may favor raising
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Basis points (bps) are measurements used in discussions of interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.
Defensive stocks provide consistent dividends and stable earnings regardless whether the overall stock market is rising or falling. Companies with shares considered to be defensive
tend to have a constant demand for their products or services and thus their operations are more stable during different phases of the business cycle.
Growth at a reasonable price (GARP) is a stock investment strategy that seeks to combine tenets of both growth and value investing in the evaluation and selection of individual
stocks. GARP investors look for companies with consistent earnings growth above broad market levels but try to avoid companies with very high valuations. By trying to avoid
the extremes of either growth or value investing, GARP investors often end up focusing on growth-oriented stocks with relatively low price-to-earnings multiples in normal market
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The Group of 10 consists of 11 industrialized nations that meet regarding international financial matters. The member countries are Belgium, Canada, France, Germany, Italy, Japan,
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The China Purchasing Manager Index, compiled by the National Bureau of Statistics of China, is based on a monthly survey of purchasing managers in 31 divisions of manufacturing
enterprise and 43 divisions of non-manufacturing enterprise.
The Purchasing Managers’ Index (PMI) measures the prevailing direction of economic trends in the U.S. manufacturing sector. It is created by the Institute for Supply Management
(ISM), and consists of an index summarizing whether market conditions as reported in a monthly survey of supply chain managers are expanding, staying the same, or contracting.
The Mortgage Bankers Association Weekly Applications covers mortgage application activity that includes purchase, refinance, conventional, and government application data,
weekly data on mortgage rates, and indices covering fixed-rate, adjustable, conventional, and government loans for purchases and refinances.
The ADP® National Employment Report™ is published monthly by the ADP Research Institute® in close collaboration with Moody’s Analytics. The ADP® National Employment
Report™ provides a monthly snapshot of U.S. nonfarm private sector Employment based on actual transactional payroll data.
The South Korea Consumer Price Index, compiled monthly by Statistics Korea, measures the average change in prices for a fixed-market basket of goods and services of constant
quantity and quality purchased by consumers.
Purchasing Managers’ Index™ data are compiled by IHS Markit for more than 40 economies worldwide. The monthly data are derived from surveys of senior executives at private
sector companies. PMI data features a headline number, which indicates the overall health of an economy, and sub-indices, which provide insights into other key economic drivers
such as gross domestic product, inflation, exports, capacity utilization, employment, and inventories.
The Caixin China General Services PMI, compiled by IHS Markit, tracks sales, employment, inventories, and prices in China’s services industry. It is based on data compiled from
monthly replies to questionnaires sent to purchasing executives in more than 400 companies. Survey responses reflect the change, if any, in the current month compared to the
previous month based on data collected mid-month. A reading above 50 indicates expansion, while anything below that points to contraction.
The Eurozone Services PMI (Purchasing Managers’ Index) is produced by IHS Markit and is based on original survey data collected from a representative panel of around 2,000
private sector service firms. National data are included for Germany, France, Italy, Spain, and the Republic of Ireland. These countries together account for an estimated 78% of
Eurozone private sector services output.
The Eurozone industrial producer price index (PPI) tracks transaction prices for the monthly industrial output of various economic activities in the European Union. The index
measures price changes from the seller’s perspective and serves as an early indicator of inflationary pressures in the economy and records the evolution of prices over longer
periods of time.
The S&P 500 Index measures change in stock market conditions based on the average performance of 500 widely held common stocks. It is a market-weighted index calculated on
a total return basis with dividend reinvested. The S&P 500 represents approximately 75% of the investable U.S. equity market.
The S&P 500® Equal Weight Index is the equal-weight version of the S&P 500. It includes the same constituents as the capitalization-weighted S&P 500, but each company in the
S&P 500 Equal Weight Index is allocated a fixed weight, or 0.2% of the index total at each quarterly rebalance.
The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 7% of the total market capitalization
of the Russell 3000® Index.
Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell
Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data, and no party may rely on
any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express
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