Last week, we discussed how stocks moved into a 10% correction after falling the previous three months. We also noted that this was normal, as 22 of the past 44 years saw a 10% correction, with many of those years still finishing much higher. Although many were worried, the economy remained quite strong and odds were high the Fed was done hiking rates. As a result, the S&P 500 Index gained close to 6% last week and climbed above the key 4,200 level. Rising above this significant point means recent lows are a false breakdown. To see prices back above 4,200 is quite bullish, especially considering the level of fear last week was consistent with many other major lows.
- Stocks soared last week, marking the best week of the year and potentially kicking off a year-end rally.
- Historically, November and December are strong months, and we expect this year to be the same.
- Many sentiment indicators flashed extreme levels of fear prior to the market bottoming, consistent with major market lows.
- Friday’s October payroll report was weak enough to reduce fears of an aggressive Fed but strong enough to limit concerns about a recession.
- The economy is normalizing, which could loosen tight financial conditions and boost cyclical activity.
So, will we get an end-of-year rally? We still think the odds favor a rally and last week’s momentum was only the start. Some more good news: November is typically the best month of the year for the S&P 500, averaging a gain of 1.7%, with December historically strong as well. In fact, when August, September, and October are all down, such as they were this year, November has never fallen lower and December has typically been strong.
Why the October Payroll Report was Helpful for Markets and the Fed
The October payroll report was weaker than expected on several fronts:
- Monthly job growth came in at 150,000, which was below expectations for a 180,000 gain.
- The unemployment rate ticked up from 3.8% to 3.9%.
- Average hourly earnings growth rose at an annualized pace of 2.5% in October, well below expectations for close to a 4% increase.
But here’s some perspective on those numbers:
- Job growth was impacted by the United Auto Workers strike, which pulled manufacturing employment down by 33,000, and those jobs will return next month.
- Monthly job growth numbers can be noisy, and so the three-month average is helpful to review. That number is 204,000, which is above the 100,000-125,000 required to keep up with population growth.
- The unemployment rate doesn’t stay steady, nor does it keep falling in a straight line during expansions. Between 1996 and 1999, the unemployment rate averaged 4.8%.
- A few days ago, the Bureau of Labor Statistics reported that layoffs are running around 1.5 million a month, which is well below the average of 1.8 million in 2019.
- As a percentage of employment, the layoff rate is now at 1%. Before the pandemic, this averaged 1.2-1.3%. The y-axis in the chart below is removed to show the layoff rate more clearly (layoffs surged in March-April 2020 during the pandemic).
The October payroll report indicates the economy is slowing from its red-hot pace. However, that is normalization rather than recessionary. It is also just what the doctor ordered for markets, and especially for the Federal Reserve.
Good News: Fed Rate Hikes Are Probably Done
Here’s how markets reacted to the payroll report:
- Equity markets surged, rising more than 0.5% in the morning.
- The 10-year yield fell to 4.5% from around 5.0% 10 days ago.
- The probability of a Fed rate hike in December collapsed to under 10%, and the probability of one in January is now under 15%.
It’s safe to say investors think the Fed is done with rate hikes, and they’re taking that as a positive sign for equity markets. The 10-year yield had been rising for a few months on the back of one strong economic data point after another, culminating in the third quarter GDP report, which showed the economy growing at 4.9%. Conditions were bound to turn sooner rather than later, as the economy certainly wasn’t going to grow anywhere close to that going forward. But we believe the underlying speed of the economy is close to trend, around 2.5%, and is not falling into a sharp slowdown or recession.
The Fed kept interest rates steady at 5.25-5.5% at its November meeting, pausing for the second meeting in a row. At the September meeting, members had penciled in one more rate hike for 2023. However, in his press conference, Fed Chair Jerome Powell brushed this away, saying the efficacy of those projections deteriorates within three months and Fed members could change their views.
Powell went on to say that risks are more balanced now. Last year the risk was that the Fed wouldn’t do enough to curb inflation, and so members moved aggressively. However, right now, there’s a risk of doing too much and unnecessarily sending the economy into a recession. Fed members believe the cumulative impact of everything they’ve done so far is yet to impact the economy.
Moreover, if inflation continues to head lower, which is likely with wage growth cooling, the Fed may pivot to rate cuts by the middle of next year. Average hourly earnings have run at a 3.2% annualized pace over the past three months, almost matching the pre-pandemic pace. That’s still strong, but the Fed can likely live with it.
If inflation appears to be on a sustainable path to the targeted 2%, the Fed may pivot sooner rather than later. By itself, keeping rates steady when inflation is falling means policy is tightening. Powell doesn’t sound like someone who wants that. And if economic growth is at risk, the Fed could act even more aggressively.
The Powell-led Fed has been quick to pivot and act aggressively when members realize they’re behind the curve.
- In 2018-2019, financial stresses and a slowdown prompted an about-face and led the Fed to eventually cut rates.
- In 2020 March, facing a deep recession, the Fed didn’t hesitate to take rates to zero and instill a series of aggressive measures to ease stresses in financial markets.
- In 2022 June, facing a 40-year high in inflation, the Fed pivoted to a much more aggressive pace of tightening.
Looking ahead, a normalizing economy could result in looser financial conditions, which could boost cyclical activity. A lower 10-year interest rate will push mortgage rates lower, and that could spur more activity in the housing market. Business investment will also likely rise. Lower inflation will translate to consumers having more to spend, and household real estate wealth could be unlocked if there are refinancing opportunities. Think of someone who bought a mortgage at 8% but can now refinance at 6.5%. My colleague, Barry Gilbert, recently wrote about the pent-up strength in the economy, despite the pessimism.
Throw looser monetary policy into the mix of an already resilient economy, and equity markets may have a strong catalyst to shift gears higher.