FED MEETING RECAP: MARKET GETS A WHIFF OF A PIVOT
Let’s start our recap of the epic week with the Fed meeting. Perhaps the market’s biggest fear
has been that the Fed may overdo its tightening to fight inflation and send the economy into a
painful recession, break something, or both. Last week’s Federal Open Market Committee
(FOMC) meeting, while broadly in line with expectations, did give the market a bit more
confidence that nothing would break, while also seemingly maintaining its inflation-fighting
credibility.
As expected, the Committee raised short-term interest rates by 75 basis points (0.75%) to take
the fed funds rate to 2.5% (upper bound). By the Fed’s estimate, 2.5% is the long run neutral
rate—the level where monetary policy is neither contractionary nor expansionary. As
inflationary pressures continue to run much higher than the Fed’s 2% target, the fed funds rate
needs to get above the neutral level to help balance aggregate supply and demand.
During the press conference, which took place immediately after the conclusion of the FOMC
meeting, however, Chairman Jerome Powell seemingly indicated a willingness to slow the
pace of rate hikes. He acknowledged that the economy is slowing (which is what the Fed
wants) and that the full effect of the rate hikes had not yet been felt. He said the Committee
would react to growth, labor market, and inflation data, versus only focusing on inflation data.
He also described 75 basis point hikes as “unusually large”, which helped take market
expectations for future rate hikes down.
The market now expects a peak fed funds rate around 3.3%, down from a nearly 4% rate that
was priced in last month [Figure 1]. We continue to think the Fed will likely increase rates this
year up to approximately 3.5% if the labor market remains stable. However, the central bank
could begin cutting again in the back half of 2023 if the economy shows significant weakness.
There is precedent for election pauses, so it’s no slam dunk we’ll get a rate hike at the
November 1-2 meeting FOMC meeting.
GDP REPORT WAS A MIXED BAG
A day after the Fed hiked rates by 0.75% to an upper bound of 2.50% the markets had to
digest a second consecutive quarter of negative growth. That naturally led more to ask the
question: Are we in recession?
We do not believe the U.S. economy is in recession…at least not yet. Consumer spending has
been too strong, as illustrated by the “spending on services” section in Figure 2. But the risks
are undoubtedly rising for next year.
The technical definition of recession is not two consecutive quarters of negative growth as
many believe, but rather must include these three ingredients:
1) A significant decline
2) A broad-based decline
3) A persistent decline, i.e., typically lasting longer than a few months
Importantly, recessions do not always correlate with headline GDP data. While a recession in
the next 12 months seems increasingly likely at this point, and two quarters of negative GDP
growth usually ends up being classified as a recession, this may be another case where GDP
data and recession dating do not align. The official arbiter of business cycle dating is the
National Bureau of Economic Research (NBER). The economy is still feeling the ripple effects
from the government-induced shutdowns. Of course, the U.S. had never before experienced
the massive swings in economic activity during the 2020 pandemic, making even the current
analysis more difficult.
That doesn’t take away from the fact that higher inflation is causing consumer spending to
slow, while higher interest rates are weighing heavily on business investment. Declines in
business capital spending reveal a budding weakness in the corporate sector of the economy
and could potentially be a sign of more deterioration ahead. It also doesn’t take away from the
fact that anemic growth means less profit opportunities for corporate America.
Turning back to the Fed, Jerome Powell and company will likely interpret this decline in real
growth as confirmation to slow down the pace of rate hikes at upcoming meetings. Frontloading rate hikes will eventually mean smaller hikes—possibly as soon as the next FOMC
meeting in September. The FOMC could still raise its target rate by another one percentage
point by the end of the year, but that is predicated on a still-solid job market, which is no
guarantee as corporate layoff announcements increase.
A DIZZYING FLURRY OF EARNINGS
Results last week covering about one-third of all S&P 500 companies were well-received by
the market. They weren’t all great, but with expectations so low, they were good enough to
help push the market higher.
With analysts and strategists widely anticipating estimate cuts, the key to the market’s reaction
to second quarter earnings is how well estimates hold up—and if those revised estimates are
deemed credible.
Sentiment from corporate leaders that have reported so far has been cautious, as is to be
expected, which has led to a reduction in the 2022 consensus estimate for S&P earnings per
share by about 0.8% [Figure 3] since June quarter-end companies began reporting in midJuly. We see slightly more downside to estimates as the rest of earnings results come in but
expect our estimates will remain comfortably above consensus. As we noted in LPL
Research’s Midyear Outlook 2022: Navigating Turbulence, we see corporate America
potentially growing S&P 500 EPS by 8% in 2022 to $225 per share. That forecast is still about
$3 below the consensus estimate.
The downside risk comes in 2023 where the consensus estimate has come down about $6
since mid-June to near $245. Our estimate is $235, implying further estimate cuts. However, in
the event of a recession, something more like $200 to $210 is possible. It’s not our forecast,
but it is within the range of possible outcomes.
Why do we think mid-single-digit earnings growth is still possible in 2023 with so much
pessimism out there? First, we expect inflation to come down steadily through next year,
facilitating the end of the Fed’s rate hike cycle and supporting profit margins. Second, inflation
supports revenue through price increases (where there is pricing power), particularly within the
natural resource sectors. Consider S&P 500 revenues are on track for a 13% year-over-year
increase in the second quarter, about 3 percentage points above expectations entering the
reporting period. And third, the economy was on relatively firm footing heading into this
slowdown, with high consumer cash balances, low leverage, and strong corporate balance
sheets. We may get an official recession later this year or next, but it should be mild if we do.
CONCLUSION
The risk-reward for stocks still looks favorable to us over the balance of the year based on
what we see as more potential upside than downside despite lackluster economic growth in
the first half. However, after a 12.6% bounce in the S&P 500 off the June 16 low, there is no
doubt the risk-reward has gotten slightly less favorable. The S&P 500 forward price-toearnings ratio (P/E) is back up to 17. The economic growth outlook has weakened. Earnings
estimates have fallen. The latest round of inflation data shows little progress. And our technical
analysis work suggests the path higher for the S&P 500 index is about to meet some stiff
resistance.
But here’s the good news: Most of a mild recession was priced in at the June lows with a
nearly 24% peak-to-trough decline in the broad market. Earnings estimates were expected to
fall more than they have and now reflect more realistic expectations for the second half.
Commodity prices and survey data have brought down inflation expectations which,
importantly, gives the market some visibility into where the Fed’s rate hiking campaign may
end.
Don’t forget that when the S&P 500 has dropped more than 20% over two quarters, as it did in
the first half this year, it has gained back over 21% on average in the next half-year and over
31% on average a full year out. And the average one-year gain off of midterm election lows,
which may have been set in June, has been over 30% historically.
Our year-end 2022 fair value S&P 500 target of 4,300-4,400 is just 4% above the July 29
closing price at the low end. We still expect a growing economy, steady, if not solid, earnings
gains ahead, and stable interest rates to fuel higher stock prices, although further gains will be
more difficult to achieve given the time it will take for inflation to come down enough for the
Fed to more strongly signal a pause and higher valuations. We continue to recommend an
overweight allocation to equities and underweight to fixed income relative to investors’ targets,
as appropriate.
IMPORTANT DISCLOSURES
This material is for general information only and is not intended to provide specific advice or recommendations for any
individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive
outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as
predicted and are subject to change.
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are
unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance
of any investment and does not reflect fees, expenses, or sales charges. All performance referenced is historical and is no
guarantee of future results.
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of
their products or services. LPL Financial doesn’t provide research on individual equities.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness
or accuracy.
U.S. Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit,
and market risk. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest
rates rise and bonds are subject to availability and change in price.
The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure performance
of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major
industries.
The PE ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit
earned by the firm per share. It is a financial ratio used for valuation: a higher PE ratio means that investors are paying more
for each unit of net income, so the stock is more expensive compared to one with lower PE ratio.
Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. EPS
serves as an indicator of a company’s profitability. Earnings per share is generally considered to be the single most important
variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio.
All index data from FactSet.
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