While the Federal Reserve (Fed) provided a 75 basis point (0.75%) increase as expected last week, the Summary Economic Outlook (SEP) provided a sobering message. The Fed no longer believes that the US can tame the inflation problem and avoid a recession. This realization is terrible news in the short term, but it’s good news that their time in the fantasy world is over.
The Fed now expects the final short-term interest rate to be 4.6% in 2023, up from 3.8% in its last SEP release. The market moved quickly to price in the new information, with the one-year Fed Funds rate now up 4.7%. Futures are now pointing to a further 75 basis points increase at the Federal Reserve’s November meeting, with another 50 basis points in December and expiring 25 basis points in February 2023.
The median SEP forecast now calls for the unemployment rate to rise to 4.4% in 2023, up from 3.9%. This increase in the unemployment rate indicates that committee members believe that a rate hike will need to negatively affect the labor market to curb inflation. In addition, according to the Sahm Rule Recession Index, an increase in this volume will lead to the beginning of an economic recession.
Cyclical stocks, the most economically sensitive, fell flat for commodities after the Fed meeting. The move reflects the rising odds of a recession in stocks. The relative underperformance of cyclical stocks has not reached June levels but may approach an area where it becomes attractive.
The S&P 500 sold off sharply last week after absorbing tough talk from the Fed. Stocks are approaching their June lows and are down 23% from their highs. While this is painful, the better news is that a lot of bad news is now being priced in. Historically, stocks have performed better than average after being more than 20% off highs. Investors with a three-year time horizon have a desirable risk versus reward ratio for investing in stocks.
In addition, investor sentiment is very negative about the stocks which has been an excellent opposite indicator. The latest AAII Investor Survey revealed that the highest percentage of people are negative on stocks since March 2009! The bear market associated with the global financial crisis ended in the same month. There are no guarantees that this will be the bottom in this bear market, but the negative reading is indicative of at least a short-term bounce back from oversold conditions.
Investors who are waiting for better economic data as a signal to reinvest in stocks are likely to be disappointed. Historically, the S&P 500 bottomed before the economy, and the initial price rebound in stocks at the start of a new bull market was explosive.
The Federal Reserve indicated that it has given up hope of a soft economic downturn while battling inflation with aggressive rate increases. On a more positive note, the markets are now carrying a lot of bad news. Futures stock returns have historically been strong after falling 20% from highs, although the S&P 500 could continue lower in the short term. In addition, investor sentiment has become excessively negative, calling for at least a rebound in stock prices. Investors must have a proper asset allocation and focus on high-quality, value-attractive companies to weather the looming recession and thrive thereafter.