Market Commentary | September 16, 2022

Schwab Market Perspective: Determined to Rise

The unexpectedly strong inflation numbers for August put paid to the notion that we've entered a new phase of rapidly moderating price growth, despite some nascent signs that inflation has peaked. What the latest data mean for the Federal Reserve's aggressive interest-rate campaign is perhaps of greater concern. 

All signs now point to the Fed maintaining its hawkish stance in the near term—and so the odds of the central bank sticking a so-called soft landing continue to shrink. Inflation rates may be slightly below their peak, but they are still far above Fed targets. A strong labor market, meanwhile, is keeping wage growth at a healthy level, potentially at a point where it could encourage inflation expectations. 

Economic growth is slowing, and signals from abroad suggest more sluggish conditions may soon be upon us. For now, though, the Fed sees plenty of reasons to keep tightening. 

U.S. stocks and economy: Dynamic inflation

Annual and monthly gains in the Consumer Price Index (CPI) have eased from their peaks, suggesting at the very least the inflation rate is no longer rising at the brisk pace of this summer. While that bodes well for consumers and investors, it doesn't provide much clarity about when (or by how much) the Fed might adjust its aggressive campaign of interest rate increases. Inflation is still above the Fed’s 2% goal, while nominal income growth and demand for labor remain strong. 

How strong? One telling measure is that workers who frequently switch jobs enjoy much stronger wage growth than those who remain in their positions longer—in fact, the spread is the widest in history. Such conditions are typically accompanied by higher quits rates, suggesting companies are still competing for workers. The Fed could see that as a risk, as it suggests inflation expectations may remain elevated. 
High turnover, high wages

For workers switching jobs at a faster rate than those who remain in their positions for longer, wage growth has been nearly 3 percentage points stronger.

Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics. Wage growth as of 8/31/2022. Quits rate as of 7/31/2022. Atlanta Fed's Wage Growth Tracker is a measure of the nominal wage growth of individuals.

The problem with an aggressive Fed is that its moves could push an already slowing economy into recession. In fact, many leading indicators of economic activity have started to decelerate, making a soft landing increasingly unlikely. 

Inflation has taken its bite out of the economy. As shown in the chart below, the annual change in The Conference Board's Leading Economic Index (LEI) is lagging the annual change in the CPI by nearly nine percentage points. Such a spread has historically been consistent with recessions. 

Inflation's bite out of growth

The year-over-year change in the Consumer Price Index (CPI) is outpacing the year-over-year change in the Leading Economic Index (LEI) by nearly 9%.

Source: Charles Schwab, Bloomberg, as of 7/31/2022.

Even when stripping out the impact of inflation, the LEI has contracted on a month-over-month basis for five consecutive months. Going back in the index's history to the 1960s, it's rare to see a contraction lasting this long without shortly entering—or already being in—a recession.

The uncertain timing of the next recession has kept investors on edge for the entire year, not least due to the bear market in multiple asset classes. 

The S&P 500's forward price-to-earnings (P/E) ratio has collapsed this year (though it remains elevated relative to its longer-term average, as well as to levels seen during prior bear market lows). Conversely, the S&P 500's forward earnings yield is still trading comfortably above the 10-year U.S. Treasury yield and is far from its most overvalued level in history (seen during the height of the tech bubble in the early 2000s). 

Expensive or cheap?

While the S&P 500’s forward P/E has declined markedly this year, it remains above levels consistent with prior bear market lows. Conversely, the spread between the S&P 500’s forward earnings yield and the 10-year U.S. Treasury yield remains positive, suggesting stocks don’t look overvalued.

Source: Charles Schwab, Bloomberg, as of 8/31/2022.

Given these measures, it’s hard to say stocks are either overvalued or attractively priced. The reality is that at any point in the market cycle, bullish and bearish investors can find metrics that suit their outlook on the market. 

With monetary policy growing tighter and growth slowing, we continue to encourage diversification and rebalancing. Investors who like to pick stocks should focus on companies with strong profit margins and positive earnings revisions. 

Fixed income: Inflation is easing but the Fed is not

While the recent drop in commodity prices—especially in gasoline prices—is a welcome sign that the rate of price gains may have peaked for the cycle, the inflation rate is still three to four times higher than the Fed's 2% target. In a recent speech, Fed Chair Powell left no doubts that his number one priority is to bring inflation down, even though it will likely cause "pain for some households and businesses."

The federal funds rate—the overnight lending rate banks charge each other—is now seen rising to more than 4% by the spring. In addition, the Fed is picking up the pace at which it is allowing its holdings of bonds to shrink, which is another way to tighten policy. Because changes in monetary policy take a while to work into the economy, we aren't likely to see the impact of these moves until later in the year—even after accounting for the fact that this has been the fastest rate hiking cycle in modern history and the economy has already slowed.

The pace of Fed rate hikes is rapid compared to previous cycles

 Interest rates have gone higher much more quickly than in any previous rate-hiking cycle.

Note: Data is the short-term interest rate targeted by the Federal Reserve's Federal Open Market Committee (FOMC) as part of its monetary policy.
Source: Bloomberg. Federal Funds Target Rate - Upper Bound (FDTR Index), using monthly data. Past performance is no guarantee of future results.

The Treasury market is, in fact, already pricing in the possibility that Fed rate hikes could lead to a recession. The Treasury yield curve is inverted—a reliable indicator of future recession. Two-year yields have been consistently higher than 10-year Treasury yields since July. Another rate hike by the Fed will likely leave the entire yield curve—from 3-month rates to 30-year rates— inverted. 
Two-year/Ten-year Treasury yield curve

The two-year/10-year Treasury yield curve has inverted.

Note: Rates represent the Market Matrix U.S. Generic spread rates (USYC2Y10). This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100.
Source: Bloomberg. Market Matrix US Sell 2 Year & Buy 10 Year Bond Yield Spread (USCY2Y10 INDEX). Daily data as of 9/12/2022.

Watching wages and expectations

Despite these worrisome signals, the Fed appears most focused on bringing down wage growth and inflation expectations. Average hourly earnings have been rising at a fast rate since the end of the pandemic. At 5.2% year-over-year, wage growth is well above the 2% to 3% rates that prevailed in previous expansions and could add fuel to consumer spending and inflation pressures. One potentially mitigating factor  is a sign more workers are re-entering the labor force. That could mean wage increases will level off as the supply of labor increases. 

Wage growth shows some signs of stabilization

Wage growth is showing signs of stabilizing, if at a fairly high level.

Source: Bloomberg, using monthly data as of 8/31/2022. US Average Hourly Earnings All Employees Total Private Yearly Percent Change SA (AHE YOY% Index).

Inflation expectations, however, have been falling sharply over the past six months. Both market and survey-based measures show that consumers expect inflation to retreat over the next two to five years. Even the Fed's own survey of consumer expectations points to a declining trend. 

NY Fed survey of three-year inflation expectations have fallen

The NY Fed's survey of three-year inflation expectations has fallen to 2.2% from more than 4% in recent months.

Source: Federal Reserve Bank of New York. Monthly data as of 8/31/2022.

Given our view that Fed tightening will continue to slow growth and cool inflation, we believe that the worst of the rise in bond yields is probably behind us for this cycle, and that the more rapid and forceful Fed tightening is going forward, the higher the risk of recession. In this environment, the dominant trend is likely going to continue to be an inverting yield curve.

Global stocks and economy: Recession may have arrived

The global composite purchasing managers' index (PMI), a timely indicator of global economic activity, fell 1.5 points in August to 49.3—its first dip below 50 since 2020. Any reading below 50 suggests economic activity is shrinking. 

The PMI for the manufacturing sector in August fell to 50.3, implying that global industrial activity has stalled. Leading measures such as new orders and the export orders sub-components also dropped, offering a potential warning that the manufacturing PMI for September could dip below 50 into contraction territory. Looking across the 37 economies measured by a PMI, the percentage that have manufacturing PMIs above 50 has plunged this year.

The percentage of economies with PMIs above 50 has fallen sharply

The share of economies with PMIs above 50 has fallen sharply this year.

Source: Charles Schwab, Macrobond, data as of 9/7/2022.

The global manufacturing PMI tends to lead the trend in earnings growth for the global companies in the MSCI World Index by about three months. The chart below shows this long-term relationship and points to the risk of an "earnings recession" beginning in a few months. Earnings have proven resilient to the slowdown so far, but the increasing evidence of slowing growth means we should expect less-sanguine financial forecasts from business leaders during the coming third-quarter earnings season. 

A coming "earnings recession"?

The drop in the global manufacturing PMI portends a potential drop in forward earnings forecasts.

Source: Charles Schwab, S&P Global, MSCI, Macrobond data as of 9/8/2022.

The good news? The earnings recession may be mild. Weak demand has allowed supply conditions to improve, leading to a significant easing in price pressures. Supply chain stress has improved, with the share of firms reporting long delivery times now at its lowest level in 22 months. The news release for the global manufacturing PMI mentioned the potential for "excess capacity developing in the manufacturing sector"—as we have been forecasting for second half of 2022 since late last year. Input costs for businesses are easing, even for European firms, despite high energy costs due to the war in Ukraine. 

August's drop in the input prices subcomponent of the eurozone manufacturing PMI, which offers business leaders' assessment of their costs for inputs such as raw material and energy, was the fourth such monthly decline in a row. It appears that the drop in the cost of steel, copper, and nickel is offsetting the rise in energy prices.

Energy accounts for about 1% of the operating expenses of many global companies, according to an analysis of such businesses' income statements. Raw materials can account for about 60% of total costs for more resource-dependent firms. In more labor-intensive services businesses, wages and benefits can make up 70-90% of costs. 

Input prices continue to fall

Input price pressures have fallen to their to their lowest level since the start of 2021.

Source: Charles Schwab, Bloomberg, data as of 9/7/2022.

As the third quarter earnings season approaches, we will be focusing on the changing business conditions and the risk of an earnings recession.

 

Kevin Gordon, Senior Investment Research Manager, contributed to this report.