What did the markets do this week and why did they do it?
Yeah. Thanks, David.
Look. This week was a bit of a tug of war.
On one side of that tug of war, we saw the big cap tech earnings.
They were, in a word, disappointing. In fact.
And you noted this upfront, it wasn't necessarily the 3Q results, it was the
guidance across the board between advertising revenue, between cloud
computing demand. We're seeing a softening there and that
really dragged down the NASDAQ. But on the other side of this tug of
war, we saw the Dow up nearly 6 percent this week.
Now, what was driving that? Well, we are certainly starting to hear
a little bit more optimism about a Federal Reserve that may be looking to
raise rates at a more moderate pace. Now, of course, next week's meeting, the
75 basis point, the point seven five percent rate hike almost baked into the
cake. It's probably going to happen, but
really all eyes will then focus on that December rate hike meeting.
Will they go 50 basis points or will they go 75?
And in fact, we heard a little bit more from some Fed governors that perhaps a
more moderate rate of rate hikes probably makes sense here.
Just given giving them an opportunity to pause, assess the economy, see what's
happening. So interesting moves in the market this
week. We do think more broadly some of those
inflationary trends that we have been seeing from the forward looking
indicators are starting to show some signs of rolling over.
That gives the Fed a little bit more comfort in perhaps going at a more
moderate pace. We certainly saw that from the Bank of
Canada this week. This as well, who went 50 basis points
rather than the expected seventy five. Peter, what do we see?
We heard from on we're hearing some optimism about the Fed.
Where are we hearing that from? I don't remember the Fed giving us
money. I think the Fed isn't giving us any
optimism. I think that is an interesting case of
are you actually listening to the people who have the power to move the interest
rates if you're actually listening to the Fed?
I think it's pretty clear the Fed's moving to squash inflation and they're
not going to stop until inflation goes down.
Inflation's sticky and it's not going to move so quickly.
And so the likelihood is, is that we see high rates or higher rates and that
those rates probably top out sometime in twenty and they don't go down until well
into 20 feet or perhaps twenty four. And I think the market is completely
digested that and they're looking for scintilla of hope that are floating
around in the market that I would call a sentiment, but not fact.
Mona, what do you make of it all. The Fed I think wants some consistent
data over time. This shows that the inflation really
coming down. You said they're a little bit
indications around the edges. Yeah.
Yeah. You know, look, Peter has a point there.
They want clear and consistent evidence of inflation moderating.
And in fact, they don't want to indicate anything too prematurely.
They started to see that in June and we saw markets start to rally.
You know, financial conditions start to ease rather than tighten, which is what
they really want to see in markets in order to push inflationary pressures
down. But if you look at leading indicators,
things like break even inflation rates, you know, I assume prices paid both
services and manufacturing. If you look at even a broader commodity
indices, we're starting to see some signs of cracks, notably the housing
market. And that's the most probably interest
rate sensitive part of the economy over the last couple of weeks.
We've seen some real weakening there in terms of homebuilder sentiment.
Housing starts, even price appreciation. That's really kind of moved lower and a
more meaningful way. And so, you know, with mortgage rates
over 7 percent at this point, we are starting to see some cracks there.
Now, keep in mind, the shelter and rent components of CPI are sticky and they
may lie. What we're seeing in the actual housing
and even in the actual rental markets. But at some point, the Fed will have to
acknowledge that we are starting to see some of some of these cracks appreciate.
And in fact, we will probably need to still get that clear and consistent,
evident evidence of inflation rolling over.
But markets won't wait for the Fed to announce that they're going to start
thinking ahead of time, looking past just like they look past this week, some
of these weaker earnings, potentially a weaker even rate of economic growth
going forward. But markets tend to move about six
months ahead of all of that as well. So probably an interesting time to start
thinking about positioning, especially for the year ahead.
You know, I think I just thought the moves point on the tug of war.
You know, part of the tug of war was driven by nominal growth rates because
inflation is very high, prices being reset, companies are increasing their
prices and the revenues are going up. Their revenues are actually going up
faster than their unit growth. In fact, some of the unit costs are
actually going down, but revenues are still going up.
So that's producing growing earnings. And that was somewhat unexpected in that
street with somewhat unexpected. You saw it mostly in the down companies,
the financial entities and Dow companies benefited from a much higher rate
environment and much higher net interest income.
But that is going to slow because when the nominal growth rate slows and when
the Fed finally gets to. A slower economy.
Those numbers are going to shift. And then those companies that are now
benefiting from that, you're going to see some headwinds.
So, Mona, does the Fed need that now growth to slow or even go down in order
to get their arms or inflation? Can we get to where the Fed wants to go
without that nominal growth suffering correction?
Yeah. That's a pretty narrow path to get to
what we call the soft landing and see inflation come down in a meaningful way.
Now, you know, what the markets have probably already priced in is some sort
of mild recession in the first half of 2023.
And keep in mind, historically, if we do get that scenario, markets are down on
average 25 to 35 percent. Every cycle is unique.
But we have gotten down to 25 percent in the S&P over that in the NASDAQ already.
And so at this point, you know, if we continue to see softness, as we
mentioned in the economics and even in the earnings figures, markets may start
to look past that. Now, what's interesting here is, of
course, to Peter's point, what's held up very well this year thus far, of course,
has been value parts of the market, defensive parts of the market.
Think about your health care, your staples, your utilities, all also kind
of inflationary hedges. Their question is, as we get towards a
peak potentially in a Fed funds rate, as we look towards the 10 year Treasury
yields stabilizing and potentially moving lower.
Do we want to start complimenting some of that value defensive with maybe
starting to pick up quality parts of growth?
Similarly, in the bond market, we've seen huge kind of influx into the
shorter end of the curve that that too you're avoiding any sort of duration
plays as the Fed is raising rates and rightfully so.
But now, as we're thinking about the end of that thing, about inflection points
more than anything else, probably an interesting time to start thinking about
complimenting your bond portfolio as you can finally lock in 10 years close to 4
percent. That's a pretty phenomenal non zero rate
that we've seen over the last 10 years that investors can start thinking about
more seriously. People are looking at losses in the U.S.
Treasury market. If you own 10 year treasuries, they're
down 18 percent, total return to the lowest point.
People are probably afraid of duration right now, and that means it's probably
a good time to buy. If you look at the equity markets, let's
look at the small cap market for a second.
Russell, 2000 probably bottomed in June and is probably looking towards, you
know, some kind of stability and growth into the first quarter of 2023.
That's the tug of war we're talking about to the cyclicals.
The larger cap companies benefit in this nominal growth rate, though, they're
still creating some value for, you know, for investors.
But the real opportunity going forward is not going to be in those stocks.
It's going to be in the small cap space, in the growth space.
You know, as I say, at the end of the day, you want to buy a company whose
earnings go at 15 percent, not earnings growth, 5 percent.
And that's still going to hold true going forward.