Nearing the final stretch

FOMC Recap and 4Q 2023 Outlook

As we gear up for the last two months of the year, we’re updating our outlook to incorporate the latest Fed meeting. Link to prior outlook.

The Fed left interest rates unchanged at 5.25 to 5.50% during their latest FOMC meeting, citing tightened financial conditions, lower credit outlays, and the yet-to-be-felt cumulative effect of monetary policy. In their press release, they noted strong economic growth in Q3 2023, but see risks as being double-sided and prefer a cautious stance. During the press conference and Q&A session, Fed Chair Jerome Powell stated that policy was restrictive, and that the Fed would remain restrictive in policy until they were confident that inflation was on the right path to the Feds’ 2% objective. Powell did note that stronger economic growth could warrant further rate hikes.

Key Takeaways

• Chair Powell said financial conditions had tightened recently driven by higher longer-term yields -- for context, the US 10-Year Treasury Yield was flirting with ~5.0%, up from 4.4% during the prior FOMC meeting.

  

  Arrows depict FOMC meetings.

• The Fed will watch financial conditions and sees that as supporting monetary policy as long as (1) tighter conditions are persistent, and that (2) the move in longer-term rates was not just a reflection of expected policy moves.

  

  Red line depicts financial conditions at 0, above the red line is “easier” and below the red line is “tighter.”

• A key point of discussion among FOMC members was whether policy was as restrictive as it needed to be; however, the takeaway Powell expressed is that the Fed is willing to raise rates again in the future if inflation accelerates.

  

  The market implied real rate (10-Year US Treasury Yield - 10-Year US Breakeven Rate) is at levels last seen during the great financial crisis.

Economic Outlook

We think that the Fed is done raising interest rates for now and expect the Fed to shift stance from hawkish to dovish as the path of data worsens through the quarter. Our base case is for a recession by the end of the year, and hold that view with moderate confidence.

Scenarios:

We consider four scenarios in our outlook — a “goldilocks” scenario where growth reaccelerates, a hard landing (recession), a soft landing (no recession but weak growth), and a stagflationary outcome (weak growth and high inflation).

Goldilocks -- 15% Chance

• Unemployment rate stays below 4%

• US GDP does not dip below 1% QoQ SAAR

• Inflation moderates to ~2%

• Reacceleration in survey data, lending, and new orders

Hard Landing (Recession) -- 45% Chance

• Unemployment rate exceeds 4.2%

• US GDP dips below 0% QoQ SAAR

Soft Landing -- 30% Chance

• Unemployment fluctuates around 4%

• US GDP growth between 0.5% and 2% QoQ SAAR

• Inflation moves below 2.5% by 12/2024

Stagflation -- 10% Chance

• Unemployment fluctuates around 4%

• US GDP growth is tepid (averages below 1% QoQ SAAR)

• Inflation remains above 3% by 12/2024

We believe that the Fed is currently on track for a soft landing. However, our view is that the Fed will not begin to cut interest rates fast enough, which means a soft landing will slip into a hard one by the end of this year. We do not see a big risk of a stagflationary outcome, as the structural impediments required currently do not exist. A goldilocks outcome, where economic activity accelerates, is also not very likely, though in our view, is more likely than a stagflationary outcome.

Why we think a recession is the most likely outcome:

• Interest rates remaining elevated despite an expected drop in nominal GDP -- with interest rates at above 4.5% on the US 10Yr, the market implied real rate is over 200 bps, which we think is excessive.

The average lines show where real rates were (1) in the runup to the Great Financial Crisis (“GFC”), (2) post-GFC, and (3) post-COVID.

• Weaker consumer impacted by depleted excess savings, a restart of student loan repayments, and lower wage growth -- this is showing up already in credit card and automotive delinquencies (though we should note that for the former, we are normalizing back to pre-covid levels).

  

  Surveys of consumer sentiment have moved lower after peaking at the end of Summer 2023.

• Tighter lending standards and lower credit growth (via SLOOS), weak new order growth, and dwindling backlogs pose a risk to employment levels.

ISM Manufacturing PMI New Orders and Backlogs have remained under 50 for over a year.

• Fiscal impulse and stealth easing post-SVB and UK LDI debacle during 1H 2023 are fading.

Our custom proxy of liquidity shows its steady decline through the year after the brief surge around the regional banking crisis.

Cross-Asset Strategy

Our cross-asset strategy is driven by the economic path we see unfolding -- a deteriorating labor situation will result in a recession by year end.

• We expect interest rates to remain elevated between 4.2 - 4.8% on the US 10Yr before sliding below 4.0% as employment data weakens further.

• Sector and factor rotation within equities should support tech and defensives vs. cyclicals and small cap. Our year-end target for the S&P 500 is ~4,300. However, near-term seasonal factors should boost equity returns through early December.

• We are neutral on housing, as structural shortages may offset a pickup in volume.

• The dollar should initially outperform DM peers, as Eurozone's contraction is happening at a quicker pace.

While we still two more sets of employment and inflation prints left for the year, we remain worried that risks are tilted to the downside.

If you have any questions, comments, or feedback, please don’t hesitate to message me directly.

Sincerely,

Muhammad Wahdy
Portfolio Manager
Wahdy Capital