- S&P 500 gave up gains in the third quarter as Fed pivot bets faded
- Chair Jerome Powell hinted at engineering an economic slowdown
- This may hurt Wall Street, alongside a potentially higher US Dollar
Equities Third Quarter Recap – Still Fighting the Fed
It was a volatile ride for global stock markets in the third quarter. Global monetary tightening to curtail strong inflation came at a cost. Focusing on Wall Street, the early portion of the third quarter was wishful thinking. Some markets rallied as much as 20 percent in anticipation of a Fed pivot next year. This reversed course as the fourth quarter neared.
September’s Fed rate decision solidifies the central bank’s inflation-fighting message. Below, the median dot plot projects a 4.63% rate for 2023, up from a 4.38% estimate in 2022. Yet, the market continues to underprice the central bank’s hawkishness. The green bars below show the spread between Fed and overnight index swaps’ projections. A 0.57- and 0.78-basis point gap holds for 2023 and 2024, respectively. This means there might be room for markets to converge with the Fed, an ingredient for more volatility in the fourth quarter.
“There is not a painless way to get inflation behind us,” said Fed Chair Jerome Powell.
September Fed Dot Plot Analysis
Data Source: Bloomberg, Chart Created by Daniel Dubrovsky
Can the Economy Withstand the High Fed Rate?
There is a reason why the Fed is tightening so aggressively, the economy has been running too hot, allowing runaway inflation. The chart below shows a custom US economy momentum indicator. Each month, the indicator can generate a maximum of nine points. This comes from three economic data prints: non-farm payrolls, the unemployment rate and headline CPI y/y.
Each event can generate a maximum of 3 points based on whether the value was relatively positive, how it compared to expectations and how it performed versus the previous month’s outcome.
The points are then added. Values closer to 9 indicate stronger economic activity and vice versa. Finally, a 12-month rolling Simple Moving Average is applied to capture a smoothened trend.
We can see that the indicator had a major slump leading into the Financial Crisis of 2007/2008. After recovering, it spent most of its time consolidating. However, in August, the SMA touched its highest since at least 2005. This is a generalized and simple indicator that does not consider the full picture. But it helps support why the central bank is aggressively hawkish.
Economic Momentum is Holding Up for Now
Data Source: Bloomberg, Chart Created by Daniel Dubrovsky
Modeling the S&P 500 with Momentum and Key Variables
Using the indicator, along with other key variables in a 12-month SMA form, we can try to estimate the path of the S&P 500. This is performed below with a multivariable linear regression where all the variables are in a percent change form.
The model implies that for every percentage point increase in the 12-month SMA of the momentum indicator, the equivalent S&P 500 SMA tends to rise by 0.035% on average. This is while holding constant the Fed’s balance sheet, the US Dollar, the 10-year Treasury yield , the effective Federal Funds rate and time. All variables are statistically significant. The model has about a 60% goodness of fit (out of 100%) – see chart below.
If economic momentum slows in the coming quarters, which is an unfortunate goal for the Fed, this may not bode well for indices.
The model also shows that of all the variables, a rising US Dollar has the most negative impact on Wall Street. For every percentage point boost in USD’s 12-month SMA, the S&P 500’s equivalent tends to fall by 0.7754% holding all other variables constant. This may prove to be another key headwind for equities in the fourth quarter as higher interest rates support the greenback.
Using Economic Momentum and Key Variables to Predict the S&P 500
Data Source: Bloomberg, Chart Created by Daniel Dubrovsky
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