Strong US labor market suggests Fed has more to do

The S&P 500 rose 1.1% last week, marking its first back-to-back weekly gain since October, as Fed Chair Jerome Powell signaled a likely downshift in the pace of rate hikes, which “may come as soon as the December meeting.” The Fed has raised rates by 75bps at each of its last four meetings.

The 10-year Treasury yield fell 19bps on the week to 3.49%, the 2-year yield declined 18bps to 4.28%, and futures market pricing for the expected peak in fed funds next May fell 8bps to 4.92%. The DXY dollar index was down 2%.

In his speech at the Brookings Institution, Powell noted that several of the drivers of inflation—including production bottlenecks and goods price inflation—are easing. Although housing services inflation is likely to continue rising in the coming months, it should also begin to fall “later next year.”

Several data releases added to the picture of a weakening US economy and an easing of inflation pressures. The ISM Manufacturing PMI fell into contraction territory at 49 in November, the lowest reading since May 2020. The US core personal consumption expenditures price index, the Fed’s preferred measure of inflation, increased by 0.2% month-over-month in October, a moderation from September’s 0.5%.

But despite these signs of cooling, the US labor market is still tight. Powell described it as showing “only tentative signs of rebalancing,” with wage growth remaining “well above the levels that would be consistent with 2% inflation over time.”

JOLTS job openings fell to 10.3 million in October, but that is still 1.7 times the number of unemployed Americans. Nonfarm payrolls expanded by 263,000 in November, the slowest pace since April 2021 but well ahead of expectations for an increase of 200,000. The unemployment rate was unchanged at 3.7%, slightly above a 50-year low. Average hourly earnings rose by 0.6% month-over-month, after 0.5% in October and 0.4% in September; too high for the Fed’s liking, and heading in the wrong direction. The declining labor force participation rate—which ticked down to 62.1%—is also discouraging.

We appear to be heading for a situation where inflation is slowing from its peak, but is not on track to hit the 2% target because of rapid wage growth. We think this could eventually end up forcing the Fed to raise rates beyond the 5% terminal rate currently priced into markets. However, we still expect the Fed to moderate the pace of hikes to 50bps at the FOMC meeting on 14 December.

we still expect the Fed to moderate the pace of hikes to 50bps at the FOMC meeting on 14 December

Economic growth is likely to slow further next year as the cumulative impact of Fed rate hikes weighs on activity, in our view. This should take a toll on corporate earnings. We expect 2023 S&P 500 EPS to contract by 4%, and believe bottom-up consensus expectations for 5% growth may be too optimistic.

How do we invest?

Markets are likely to remain volatile, and we do not think the economic conditions for a sustained upturn are yet in place. But given the prospect of periodic rallies, we prefer strategies that add downside protection while retaining upside exposure.

• We prefer the more defensive areas of the equity market—including consumer staples, healthcare, and quality-income stocks—which should be relatively resilient as economic growth deteriorates. We also favor value stocks, which have historically outperformed when inflation is above 3%. In fixed income, we prefer higher-quality and investment grade bonds versus high yield.
• The US dollar has fallen by around 8% from its peak, but we expect renewed strength for the safe-haven greenback in the months ahead as the slowing global growth environment—particularly in Europe—comes back into focus. We also like the Swiss franc, and hold a least preferred view on the euro and sterling.
• Meanwhile, high equity-bond correlations this year have underlined the importance of seeking alternative sources of return, for example in certain hedge fund strategies. Macro strategies have been particularly strong performers this year, and we expect them to continue to do well in volatile markets.

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