Macro Note - FOMC Recap

Summary

• Today the Federal Reserve raised the Fed Funds Rate higher by 50 basis points, from 4.00% to 4.50%. This was the first downshift in Fed rate hikes, after four sequential 75bp increases.

• The Summary of Economic Projections (a quarterly forecast of GDP growth, inflation, unemployment, and interest rates conducted by Fed officials) pointed to an FOMC expecting weaker growth, modestly higher unemployment, and for interest rates to remain elevated through FY 2023. The median forecast for interest rates by the end of next year stood at 5.1%.

• The market reaction was negative and came from speculation that the Fed would communication an earlier pause or softening of rhetoric in the face of two soft inflation reports, a weakening housing market, and a gloomy outlook for growth next year. We see the reaction as mixed, given the balancing act Jay Powell attempted to speak to, and the level of uncertainty he implied around the Feds own outlook.

• Our view is that the Fed is potentially setting the market up for a dovish surprise in the February FOMC meeting. By adjusting up their inflation outlook for FY 23 and FY 24, the Fed is implicitly lowering the bar for improving inflation dynamics to play out. This is a positive sign for risk assets, though we remain cautious in the near-term.

Outlook for 2023

• We believe that a "soft-ish" landing is becoming increasingly likely, though risk of bad outcomes remain. We define a soft-ish landing as an economic outcome where inflation ends below 3% in FY 2023, where the unemployment rate does not exceed 4.5%, and where aggregate New Orders (through ISM PMI reports) average above 50.

• We have a few insights driving our view:

  1. Labor market tightness. The existing labor imbalance between the supply and demand supports existing payrolls, and should carry them through a modest decline in growth. This means that we do not anticipate wide scale layoffs (ex-tech, ex-housing) -- growth would have to surprise to the downside in order for firms to begin to cut employees in earnest. We do not see that happening as of now.

  2. Room for an approval global outlook. A strong labor market supports existing demand for goods and services. A rebounding global economy can spur additional growth. Recent improvements in China and Europe suggest a pick-up in economic activity during the 1H of next year, which makes us lean optimistic that growth (measured by New Orders) can avoid a sustained period of contraction.

  3. Low sensitivity to interest rates. The US economy is service-driven and is less sensitive to interest rates than it was in the 80s and 90s. This makes us skeptical that monetary policy will be sufficient in curtailing retail spending without breaking something else in the economy. We are constantly on the lookout for something like this to occur, but so far, financial conditions have remained tight but are close to their 1-yr mean.

  4. A rebound in productivity. US productivity has suffered this year, driven partially by trends in employment and wage growth (which itself was driven by rents and worker relocations). However, recent investments in technology, such as ai/ml, and other productivity-enhancing tools may result in above-trend productivity growth through the decade.

• Asset classes should begin to perform through FY 2023, with the potential for a sustained market recovery by the end of FY 2023

  1. Rates: our rate forecast puts the Fed Funds Rate at between 4.25 and 4.75 by the end of 2023, US 2Yr below 4%, and US 10Yr around 3%.

  2. US Dollar: improving inflation dynamics will remove pressure from the Fed, resulting in a modestly weaker backdrop for USD through FY 2023.

  3. Equities: we expect multiple expansion in FY '23 for the S&P 500, though believe there is moderate risk to EPS in 1H of '23. Our base case is for EPS growth of 8.5% through 2023. Our EPS target is $238.50 and our Fwd P/E is 18x. This brings our S&P 500 year-end target for FY 2023 to 4300, which is a ~7.5% return from today's price.

     • We believe that there is a significant chance for a much higher EPS target, as current estimates reflect a gloomy outlook driven by expectations of a recession in FY 2023.

     • Equity sectors we like include consumer, industrials, chemicals, metals & mining, and technology.

  4. Commodities: we expect industrial metals and gold to perform well in 2023. Energy should be range bound with WTI trading between 70-90 per barrel.

The biggest risks to our outlook include:

• Inflation that is stickier than expected, which would require the Fed to maintain a higher level of interest rates for longer

• A deep recession, which would result in a contraction in industry-wide New orders and a higher unemployment rate.