Fed Signals Slower Rate Hikes, Easing Inflation and Boosting Markets

Equity markets gained in November with signals that the Fed might slow its pace of interest hikes and a slew of better-than-expected earnings reports in the retail and technology sectors. Stocks saw broad gains on the last trading day of the month, with the S&P finishing the month up about 5.6%. The Dow gained 6%, while the tech-heavy Nasdaq lagged slightly, adding 4.5% for the month.

The equity market welcomed the less-than-expected October CPI (Consumer Price Index) data, hoping the Federal Reserve might pause on interest rate hikes sooner than previously anticipated. The headline CPI rose 0.4% in October, less than consensus had expected, and put the year-over-year increase at 7.7%, the lowest since February. Investors experienced even more relief with the deceleration of the core CPI reading, which rose 0.3% in October, bringing the year-over-year number to 6.3% (from a 40-year high of 6.6% in September). The CPI deceleration can be attributed to lower prices for used cars, clothing, and medical care services, despite the cost of housing remaining high. Notably, the softer rise in core prices partially reflected a methodological quirk in how the Bureau of Labor Statistics calculates health insurance prices, which swung from a steady rise of 2% or more since March to a 4.0% drop in October.

We believe the October CPI data is an encouraging development, but it does not warrant any significant change to our view of the Federal Reserve’s policy. We continue to anticipate the Fed will raise interest rates by 50 basis points in its December meeting. The good news is that core goods inflation finally fell (-0.4% m/m) as consumer spending shifted from goods back to services. However, core service prices remain sticky (+0.5% m/m), partially reflecting the elevated wage growth pressure driven by a tight labor market. The quit rate, a good predictor of wage growth, remains high. Job openings increased by 329,000 in October, down from 431,000 in September. Nevertheless, that moderation is probably not fast enough to affect the Fed’s determination to hike interest rates to a level that brings inflation down to its 2% target. Overall, we believe that one month’s inflation data point is not enough to change the Fed’s path of tightening monetary policy and believe that the Fed would need to see a more sustained trend of decelerating core inflation.

Another theme that dominated the news flow in November was the 2022 midterm elections. With the Senate staying in Democrats’ hands and Republicans projected to take majority control of the House, congressional leadership will be divided for the next two years. We expect that a split Congress could mean legislative gridlock, limiting any significant changes in fiscal policy over the medium term. In addition, it could increase the risk of a debt ceiling crisis, which is likely to lead to a temporary drag on government activity and some disruptions in the private sector. However, midterm election results do not typically have a significant impact on the equity market's long-term performance. Thus, we advise investors to focus more on long-term macro headwinds such as higher inflation, Fed policy, slowing growth, and corporate fundamentals. 

We remain underweight equity in the short run as we stay cautious about macro headwinds and corporate earnings uncertainty due to mounting margin pressures from elevated wage growth. This month, we utilized the equity rally as an opportunity to modestly reduce our U.S. equity exposure from 43% to 37%. We stay conservative with our international equity exposure (28%) as business activity and sentiment in Europe continue to deteriorate.