Equity Markets Still Under Pressure from Rising Interest Rates

Equity markets were under selling pressure in December, fighting headwinds from rising interest rates and a looming economic downturn. The S&P 500 finished the month down 5.8%, and the Dow lost 4.1%. The tech-heavy Nasdaq lagged significantly, losing 8.7% for the month. Within the S&P 500, the typically defensive sectors, including health care, utilities, and consumer staples fared best, while weakness in Tesla weighed heavily on the consumer discretionary sector.

During December, inflation and monetary policy continued to be the key macro factor driving asset markets. Investors got more relief on the inflation front this month. The Consumer Price Index (CPI) rose 0.1%, slightly less than the consensus forecast, bringing the year-over-year CPI down to 7.1%. More encouragingly, the core CPI rose 0.2%, the weakest monthly gain this year, with a 6.0% year-over-year increase. The deceleration in the core CPI was attributable to declines in the prices of used vehicles, medical care services, and transportation.

Despite the welcome downside surprise of the recent two months' CPI data, it remains uncertain how quickly and how low inflation might go in 2023. We have seen core goods disinflation as consumers shifted their spending from goods to services and the supply-chain issues continued to ease. We also expect shelter inflation (40% of the core CPI) to decelerate meaningfully around mid-2023 as the housing market continues to cool down. However, the category of core service inflation excluding shelter encompasses many labor-intensive sectors and will be highly sensitive to labor market tightness and wage growth. Despite some weakness in certain industries, the labor market remains resilient, with the November payroll beating expectations by a large margin. At the same time, average hourly earnings accelerated for the third consecutive month, increasing YOY earnings by 5.1%. High wage growth could be worrisome for the Fed as it might make inflation much harder to control.

Well-anticipated by the market, the Federal Open Market Committee increased the target range of the fed funds rate by 50 basis points in its December meeting, lifting the target range to 4.25% to 4.5%. Despite a slowdown in the pace of rate hikes, the Fed raised its projection of the peak fed funds rates in 2023 from 4.6% to 5.1% and asserted that the work to tackle stubbornly high inflation was far from over. New forward guidance also shows a worsening economic outlook from the committee, with projections for the core PCE inflation rate increasing to 3.5% (from 3.1% in September), forecasts for GDP reduced (from 1.2% to 0.5%), and the unemployment rate nudging up (from 4.4% to 4.6%).

December also witnessed a mixture of resilience and weakness in economic and sentiment data. The labor market data held up better than expected, while widespread weaknesses emerged from manufacturing and consumers in addition to the sharper cooling of the housing sector. For the first time since May 2020, U.S. manufacturing activity contracted in November, with the ISM manufacturing index falling to 49. The sub-groups of new orders, production, and employment all declined. Historically, it is unusual to see a tightening of monetary policy when the ISM manufacturing survey’s new orders index is below 50. However, the Fed is acting differently this time, determined to tame inflation even at the cost of below-potential GDP growth for a period. After robust growth in October, retail sales fell more than expected in November. Consumers have mostly exhausted excess savings accumulated during the pandemic, with the savings rate falling to 2.3% in October from 7.3% a year ago. Although we expect modest sales growth, consumers are getting hit by a combination of elevated inflation, high interest rates, falling housing prices, and broadening negative wealth effects from all assets, including equities, bonds, and alternative investments.