Rate Capitulation May Be At Hand

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In comments on the market, Daniel Berkowitz, senior investment officer for investment manager Prudent Management Associates wrote:

Rate Capitulation May Be At Hand

If comments issued from the Fed represent data points, the sample size is growing larger and more convincingly pointed toward the Fed taking short rates above the current rate of inflation and holding them there for longer to ensure it’s quashed. Core PCE, the Fed’s preferred inflation metric, is currently sitting at 5.1% year-over-year.

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Two recent comments bolstering this view came from St. Louis Fed President James Bullard and more recently, NY Fed President John Williams. John Williams specifically noted that, while inflation is on a seemingly downward trajectory, it may still stabilize above the Fed’s long-term target of 2%. We agree, and this would suggest a more restrictive policy stance than the market is currently positioned for through 2023.

The most recent bit of data which in our view supports a hawkish Fed policy is a still healthy, if not robust consumer. Record Black Friday sales of more than $9 billion indicate that demand for goods may continue to challenge supply. The large increase in buy now, pay later purchases bears watching, however, as this may come home to roost during 2023.

In a best-case scenario then, September’s print would represent the peak for core inflation in the US. The bond market seems convinced of this proposition, which we still find somewhat baffling—TIPS breakeven yields have significantly eased through November and now reflect an expectation of 5-year average inflation of 2.30%.

With that said, calling peaks is difficult and market indicators often don’t have a great track record of predicting the future, especially over the short term.

The Role Of Corporate Earnings

In our current environment of high uncertainty, corporate earnings will play an even larger role than usual in determining the short-term direction of the markets. While the recent rally in broad equity prices was certainly welcome in what has been a dismal year thus far, the earnings outlook for the fourth quarter is darkening.

As of last week, analysts’ consensus forecast for S&P 500 earnings was for a 2% decline year-over-year. Though the US market is far more reasonably priced from a valuation perspective than it was earlier in 2022, a bumpy ride through the next earnings season may reverse much of the recent gains.

On an unrelated note, the spread in the cryptocurrency meltdown with crypto lender BlockFi following FTX into bankruptcy reinforces our view that speculative assets do not belong in a strategic portfolio. The diversification benefit to traditional assets and inflation-hedging properties that they were touted to bring have yet to materialize—instead, for those who hold them, what they’ve added to a portfolio is pure volatility.

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.