The 1% Move Report

Wealth Management — November 2, 2022

• The S&P 500 declined 2.5% Wednesday to close at 3,760. With the sell-off, the index has now fallen 21.1% year-to-date.
• All 11 S&P 500 sectors decreased Wednesday as Utilities (-1.0%) and Financials (-1.3%) outperformed, while Information Technology (-3.5%) and Consumer Discretionary (-3.8%) lagged.
• Today the Federal Reserve raised rates 75-basis-points for the fourth consecutive time since June and Fed Chair Powell guided to additional rate increases following future meetings. Since the start of the Fed rate hike program in March 2022, rates have risen 3.75 percentage points and Fed Chair Powell indicated that the "ultimate level of interest rates will be higher than previously expected." Core services inflation continues higher and goods inflation is not coming down, to the extent the Fed anticipated by this point. 
• By the 4 pm equity market close, WTI oil was higher, at $89.2 per barrel, while the US Dollar Index was modestly higher at 112. The 10-year US Treasury yield rose to 4.08% while the 2-year Treasury yield met new cycle highs at 4.61%.

• Monetary Policy: Following the November FOMC meeting, Fed Chair Powell announced a fourth consecutive 75-basis-point (bp) hike and reiterated that "there is still a way to go to get to a sufficiently restrictive level of monetary policy" that will allow for inflation to return to 2% over time. Ongoing rate increases are likely and there will be a discussion at the next meeting on the need for another 75-basis-point hike, or if it is possible to moderate the pace of increases. Nonetheless, Fed Chair Powell emphasized that the discussion on how long to keep policy restrictive is most important and that it is premature to think about a pause in rate hikes. With core services inflation still rising and goods inflation higher than the Fed anticipated at this point in time, the clarity on when inflation will moderate sustainably is not apparent. During the Q&A session, Fed Chair Powell noted that "a soft landing is still possible, although the window has narrowed."  MS & Co.'s Ellen Zentner expects a 50-basis-point hike in December, and a 25-basis-point hike in January 2023, to a terminal rate of 4.625% in January. Additionally, she anticipates that rates will remain steady at the implied 4.625% level until December 2023 when a first rate cut of 25 basis points may occur. MS & Co. believes a 75-basis-point hike could be possible in December 2022 if core services remain under pressure. The balance sheet reduction program doubled in September. Odds of a 50-basis-point hike at the December FOMC meeting are 100%, with a 26% chance for a 75-basis-point hike, according to Bloomberg. 
• 3Q22 Earnings: So far, 347 S&P 500 companies reported third quarter results with 70% of them beating earnings expectations. In aggregate, for the companies that reported, earnings surprised by 4.4% while sales surprised by 2.3%, according to Bloomberg. Nonetheless, increasing cost pressures are evident as margin expectations are now below preseason forecasts. For the S&P 500, bottom-up, blended 3Q22 earnings growth is anticipated to be +4.1% y/y as earnings from Energy companies are driving much of the growth, according to Refinitiv. Excluding Energy, 3Q22 earnings are expected to be down 3.5% y/y. By the end of this week, 82 more companies are expected to report. During company 3Q22 earnings calls, investors will be monitoring forward guidance as well as the impact of a strong US dollar, elevated/sticky inflation, higher rates, the shift from goods to services, the inventory glut, and slowing demand conditions. We expect these headwinds to weigh on revenues, margins, earnings, and valuations. 

Calendar:

• 11/3: Productivity and Costs, Factory Orders, ISM Services, UK BoE Rates Decision 
• 11/4: Employment Situation

With the Fed responding to 40-year highs in inflation through both rate hikes and balance sheet run-off in 2022, the GIC’s call for continued caution in the indices remains intact. Corporate earnings revisions are moving lower, and valuations remain rich, especially relative to the 10-year real interest rate. We recommend that investors focus on risk management through quality cash flows, defensiveness with regard to interest rate sensitivity, and attention to stock-specific valuations. Bear market rallies should be used for rebalancing and tax-loss harvesting. In fixed income, the challenge is two-fold: generating sufficient income, while also preserving capital in a rising-rate and higher-inflation environment. This requires diversified and active exposure, with our preference for core investment grade fixed income and dividend-paying stocks. Consider revisiting positioning in long-duration/growth equities, where there may not be adequate compensation for the risks of rising real rates, falling operating leverage and the strong US dollar.

For US equities, our June 2023E S&P 500 base case provides a target of 3,900. This scenario assumes earnings and revenue growth decelerate due to high cost pressures in a slowing growth environment. Our June 2023E bear case of 3,350 considers a slowdown in earnings growth rate, margin pressure, sticky inflation and a recession. Our June 2023E bull case of 4,450 corresponds to a soft-landing environment, where earnings growth slows but remains positive, inflation decelerates, cost pressures ease, and confidence improves. This bull case forecast embeds an estimate of 17.9x MS & Co.'s forward June 2024E earnings.

Market data provided by Bloomberg.

Dow Jones Industrial Average (DJIA): A price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry.

NASDAQ Composite Index: A broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market.

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

US Trade-Weighted Dollar Index: A weighted average of the foreign exchange value of the 17US dollar against a subset of the broad index currencies that circulate widely outside the US.

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