Are stocks “fighting the Fed”?

By Gustav Reinach*

The US Federal Reserve (Fed) switched from quantitative easing (QE) to quantitative tightening (QT) combined with brisk rate hikes in 2022, which put an end to the loose monetary policies that had buoyed markets in 2020 and 2021. With U.S. stocks rising during the years of easy money and then falling for the majority of 2022 as financial conditions tightened, equity markets appeared to be particularly responsive to Fed activities. The catchphrase “don’t fight the Fed” provided an easy justification for market behaviour.  Nonetheless, Q4 2022 and January 2023 later occurred. The Federal Reserve increased the benchmark fed funds rate by 75 basis points in November and by 50 basis points in December for the fourth quarter.

By historical standards, highly hawkish. While rates continued to rise, one might have anticipated a decline in equities, but this was not the case; instead, the S&P 500 increased by 7.4% in the three months that ended on December 31, 2022. The Fed increased interest rates by 25 basis points once more in January and hinted at future increases. However, the S&P 500 gained an additional +6.18%, and American small- and mid-cap stocks performed even better for the month, rising by over +9% as the “risk-on” mentality returned to the market. The benchmark fed funds rate increased by a substantial 1.5% over the course of a four-month period, and financial conditions tightened even more. Overall, stock prices increased by close to 15%.

I’m not trying to disprove the maxim “don’t fight the Fed” with this argument. Reduced interest rates boost the value of future profits, enhance the availability of funds for investment and consumption, and stimulate the credit, lending, and economic sectors. That’s advantageous for both the economy and stocks in general. We witnessed this pattern in action in 2022. Tighter financial conditions and higher rates tend to go the other way, which can affect investor sentiment toward risk assets and lower the multiples they’re ready to pay for them.

There have been instances in the past when the Federal Reserve tightened financial conditions and raised interest rates while stock prices were also rising. The Fed raised interest rates during the bull markets of 2003–2007 and 2009–2020, as shown in the chart below. Don’t oppose the Fed didn’t work out during these times, yet stocks and the economy did quite well.

In the current climate, I observe that many investors would rather hold off on increasing their bullishness until the Fed stops raising interest rates. Yet if we think that stocks move in tandem with economic news and Fed policy—which we know historically has not been the case—we will assume that equities will only begin to rise until the Federal Reserve lowers rates or stops rate hikes. Equities rarely wait for definite signs of good news to return because they discount future economic and earnings conditions. This is evident from the last four months.

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Conclusion for Investors: There is a valid case that the market surge over the past four months was due to expectations that the Fed was close to ending its tightening cycle. Yet the reality remains that the Fed is positioning for another two, possibly three rate hikes far into the spring, and that the stock market has risen as a result of the Fed Funds moving much higher. Until the Fed formally declares it is suspending rate hikes, investors can cling to the maxim “don’t fight the Fed” and exercise caution, but I believe by that point it will be too late. Investors shouldn’t expect the stock market to wait for confirmation, and neither should they, in my opinion.

The US jobs market is still too hot for the Fed

Nearly everyone was taken aback by the US labour market in January, including the Federal Reserve, as nonfarm unemployment increased by 517,000 during the month. A little over 200,000 was the typical forecast for payroll growth in January, which the labour market far exceeded.

To be fair, given seasonal changes, the weather, and other things, January has been a strange month for data. Yet barring a significant reporting error, it’s safe to assume that the job market is still scorching hot, which is a dilemma for the Fed. While it’s true that well-known businesses, notably in the IT industry, have been making layoff announcements recently, it’s obvious that this is more of a result of over-hiring during the period of reopening following the epidemic than a sign of general economic weakness. After the payroll report, the unemployment rate decreased to 3.4%, a new 50-year low.

A tight labour market frustrates the Federal Reserve because it suggests that wage pressure could be on the rise, possibly even more likely. The good news from the report from last week was that wages only increased by 0.3% from month to month in January, with the 12-month growth rate dropping from 4.8% to 4.4%. The Fed is nevertheless cautious, especially in light of Chairman Powell’s commitment to the Phillips Curve, which holds that unemployment and inflation have an inverse relationship.

States are reporting healthy cash reserves

The US economy continues to be uneven, with declining activity in consumption, manufacturing, and services being substantially offset by the robust labour market previously mentioned. State finances are one area of strength that might help the economy endure a slump. State and local governments must balance their budgets every year, unlike the federal government, which means they must offset increases in expenditure with increases in income or reduce spending in years where tax revenue is smaller than anticipated. States frequently have to decrease spending and/or lay off employees when tax revenue declines, which exacerbates a slump.

Nonetheless, most states are entering 2023 with record-high reserves and “rainy day money,” as a potential recession looms. The National Organization of State Budget Officers estimates that states currently have $136.8 billion in cash reserves, an increase from the levels seen in 2021. States profited from both a quick recovery after the epidemic when the economy resumed operating and from an increase in federal spending that was given to the states. States are now well-positioned to withstand a downturn, should it come. 39 states have the reserves necessary to make up for revenue lost in a mild recession, according to Moody’s Analytics.

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Has the US housing market stabilised?

After two unprecedented years of price growth and sales activity, 2022 was a difficult year for the American housing market. When mortgage rates increased from 3% to over 7%, many properties started to become unaffordable due to price increases of more than 40% over a two-year period. Mortgage rates have decreased by a full percentage point, giving the market some relief so far in 2023 as investors prepare for the Federal Reserve to stop its program of monetary tightening in the first half of the year. Since the end of last year, mortgage applications have increased by around 25%, and Redfin estimates that more real estate brokers are being contacted than during a slump. But another crucial fact – pending home sales, a key indicator of the housing market, increased by 2.5% as well.

• Gustav Reinach is an advisor at Brenthurst Pretoria.