In comments on the market, Daniel Berkowitz, senior investment officer for investment manager Prudent Management Associates wrote:
Reading the Fed’s tea leaves is becoming an increasingly difficult proposition. Just this week, St. Louis Fed President James Bullard reiterated a possible terminal fed funds rate as high as 7%, but last night, Jerome Powell seemed to take this off the table at least for the first half of 2023.
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After the Chairman’s comments, terminal rate expectations gleaned from derivatives markets eased slightly to 5% from a week ago.
Inflation Rate Is Still Too High
Five percent is certainly a much more reasonable terminal rate expectation given where markets sat earlier this year, though downside risk still exists to the extent inflation proves sticky. Core PCE, one of the Fed’s preferred inflation metrics used to calibrate interest rate policy, recently came in at 5% for October year-over-year.
Though this represents a slight slowdown from September’s reading, core PCE has hovered around 5% since the beginning of this year. The disinflation we are experiencing is welcome, though inflation rates still remain far too high to declare victory.
A mixed bag of forces is still pushing and pulling inflation in both directions, but to be clear, forces putting upward pressure haven’t completely dissipated. Economic activity is clearly slowing and supply chain pressures are easing. But the US labor market is still running strong and wage growth currently sits at levels inconsistent with the Fed’s 2% long-run mandate.
Even with myriad technology companies announcing large-scale layoffs, jobless claims fell last week to a seasonally adjusted 225,000. The strong labor market, in conjunction with cushion from pandemic era stimulus, continues to buttress household spending.
In our estimate, inflation and interest risk continue to remain elevated in the short term. As of today, the yield curve is highly inverted beyond short-term maturities, providing limited compensation for taking material duration risk—in fact, the spread between 2-year and 10-year Treasury yields recently touched levels not seen since 1981.
TIPS inflation breakeven rates, which eased in November with falling inflation prints, still reflect overly optimistic expectations for inflation’s future path in our estimation.
With that said, looking ahead to 2023 and beyond, we remain cautiously optimistic in our outlook for a balanced portfolio. Even with the earnings picture darkening for US corporations, US equity valuations look far more reasonable now than they did earlier this year.
International equity valuations also continue to remain compelling, though attractive dividend yields and the possibility of a material decline in the US dollar brighten the outlook. And even with November’s recent drop in rates, the 10-year Treasury yield still sits at about 3.5% with meaningful spreads in investment-grade and high-yield fixed income, boosting the appeal of US bonds.
About Prudent Management Associates
Prudent’s core investment philosophy focuses on minimizing risk over time. As a result, the company does not react to market events, but rather considers them in a larger context to develop a long-term outlook for the development and maintenance of investment portfolios.
