Why the S&P 500's recent surge is not a bear market rally

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After months of beating around the bush, the Fed finally marshalled a very clear, concise message for markets at the Jackson Hole Forum. And the message was this.

Rates will go to moderately restrictive territory. And rates will remain restrictive for some time.

This was a message that flies in the face of a lazy consensus that has been driving markets – both equities and bonds – recently. And that is going to have a meaningful impact on the outlook for equities and bonds.

The Fed knows lazy consensus

The characterisation of inflation as “transitory” arguably landed the Fed in this predicament. Transitory was the lazy consensus post-pandemic as markets, economists and central banks ignored the possibility that inflation may remain too high, for too long.

The Fed has been battling to restore credibility for most of 2022.

The Fed has found the messaging challenging. And markets have been volatile as investors groped around for a plausible economic outlook. But that consensus outlook recently settled on the following outlook:

  1. Rates will be hiked rapidly to the terminal rate,
  2. The US will enter a shallow, short recession,
  3. Rates will be cut in 2023,
  4. Inflation will settle at or above the Fed target and rates will normalise somewhere above the levels of the past decade.

The combined commentary from Fed Chair Powell and Fed Presidents Bostic, Harker, and Bullard has clarified the outlook. Their message – rates will go to moderately restrictive territory. And rates will remain restrictive for some time – provides a clearer playbook for investors over the coming 12 months.

Why rates will go to a moderately restrictive territory

Headline inflation is too high. Core inflation is too high. Rates need to move to restrictive and stay there. As Fed Chair Powell said in his speech: “estimates of longer-run neutral are not a place to stop or pause.”

We estimate the neutral nominal cash rate in the US to be 3.0%. Lower than it has been historically. But higher than the Fed Funds rate is set today. That sets a lower bound for the Fed Funds rate this year.

Federal Reserve Bank of Philadelphia President Harker said on Friday that the Fed Funds rate would need to get 3.4% or above to be appropriately restrictive. Federal Reserve President of Atlanta President Bostic indicated a similar level – suggesting 1.0% or 1.25% more rate hikes from here. This is as clear as a central bank can be.

And rates will remain restrictive for some time

This message is not what the market has priced. Instead, the market expects rates to be hiked rapidly to around 4.0%, then cut early in 2023.

Chart 1: Markets are still pricing a pivot, not a pause, from the Federal Reserve

Source: Bloomberg, Oreana Portfolio Advisory Service

The Fed is now being clear that they will pause, not pivot. That pause could be months. It could be years. But we expect the Fed will pause through most of H1 2023 before revisiting and potentially hiking again in H2 2023 – a pathway shown in Chart 1. Importantly, the pause will allow the economy to digest the front-loaded rate hikes. And that will extend the current cycle.

A recession is inevitable – eventually

The US yield curve (the difference between 10-year and 2-year Treasury yields) is very inverted. That has historically always pointed to recession. But the lag between inversion and recession can be lengthy.

Furthermore, inversion is no barrier to equity markets outperforming analyst expectations. We expect the Fed’s pausing cycle will extend the economic cycle – and delay the recession. That is good news for investors after challenging and volatile markets through H1 2022 – if you are willing to listen to the Fed and position appropriately.

A better outlook for bonds and equities

Equities did not respond well to Fed Chair Powell’s speech at Jackson Hole. But the message is a positive one. The Fed will move to restrictive settings, but will then pause. The economy will slow, but not enter recession in the near term. Shorter-dated Treasury yields may remain elevated, but longer-dated Treasury yields have likely already peaked. And to cap it off, inflation has already started to move lower.

The upshot is US earnings outcomes that are likely to exceed bearish estimates over the next 12 months. And that means the recent surge in the US S&P500 is not a bear-market rally – but a sustainable recovery relative to pessimistic expectations.

The message is even clearer for those who include US Treasuries in their portfolios. Yields have sold off to be above 3.0%. These levels provide meaningful income, meaningful downside protection, and meaningful diversification for diversified portfolios.

Don’t fight the (credible) Fed

After getting the path of inflation wrong, the Fed battled to restore credibility through the first part of 2022. The messaging was difficult to interpret. That challenge drove volatile markets and pain for investors.

Jackson Hole was the soapbox the Fed needed to drive home a credible, clear message. And that is what they have done. It boils down to this.

Rates will go to moderately restrictive territory. And rates will remain restrictive for some time.

Investors need to prepare for an extended economic cycle, better outcomes than are currently priced, and upside risk for bond and equity returns over the coming 12-18 months.

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