IWM - Where Is The S&P 500 Headed After The Fed's Widely Expected Rate Hike?

2023-07-26 16:27:28 ET

Summary

• The Fed raised rates by 25 bps, as widely expected.
• Impact on high-yield S&P 500 stocks discussed.
• S&P 500 at 4,700 assessed.
• Expectations of 2% inflation in 2025 at the earliest discussed.

The Federal Reserve raised interest rates again by 25 bps, as widely expected. In the FOMC statement , the Fed cited persistently elevated inflation, low unemployment, and a strong banking system as reasons to raise the federal funds rate.

The committee reiterated its objective of achieving maximum employment and 2.0% inflation over the longer run. At a target range of a federal funds rate of 5-1/4 to 5-1/2, where will the S&P 500 ( SP500 ) go next?

Uncertainties Persist But Markets Complacent

The Fed wrote that “tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation.” However, it's uncertain about the extent of these effects. Most notably, the committee is watching inflation risks attentively, as discussed in this CPI report review here . Unusually, markets throughout this year grew both more bullish and complacent. Conversely, after the FOMC announcement, the 2-year treasury ( US2Y ) gained 0.30% while the longer-term 30-year bond ( US30Y ) fell by 0.38%.

The bond market’s reaction steepened the inverted yield curve. It's pricing in a growing risk of an economic recession that will result from the tightest level in 22 years .

Stock investors are effectively “fighting the Fed” by expanding price-to-earnings multiples of the S&P 500 and Nasdaq ( QQQ ). Although the Magnificent Seven, including Apple ( AAPL ) and Microsoft ( MSFT ), accounted for much of the index’s gains, markets are not entirely irrational. For example, corporate investments in artificial intelligence, lifted Microsoft’s Intelligent Cloud revenue by 15% year-over-year to $24.0 billion .

Impact of Fed Funds Rate Range Increase

The committee’s 5.25% to 5.5% federal funds rate range increase may increase pressure on the stock price of dividend income companies on the S&P 500. Fortunately, income investors may accumulate stocks whose dividend is at or above 5.5%. Altria ( MO ) yields 8.2%, Verizon ( VZ ) yields 7.6%, and AT&T ( T ) yields 7.5%.

Particularly in the telecom sector, investors who took advantage of fears of litigation risks from lead cable bought T and VZ stock. AT&T responded by testing lead levels first, pausing plans to remove them from Lake Tahoe .

Investors might not sell dividend income stocks when the dividend yield is below 5.5%. However, they may reduce holdings in companies that have weak growth. This includes Organon ( OGN ), Viatris ( VTRS ), and Ford Motor ( F ).

In May 2023, Organon sold off when it posted a Q1 profit contraction . The supplier of women’s health posted revenue falling by 1.8% Y/Y to $1.54 billion. Viatris posted revenue falling by 11% in Q1/2023 . The fall in earnings hurts the generic drug supplier’s ability to raise its dividends.

Per the table above, OGN and VTRS stock score poorly on growth.

Ford and other vehicle makers risk a severe profit margin contraction. The firm cut prices of its electric F-150 . Investors did not believe Ford cut prices to pass savings to customers. Instead, demand is weakening for high-priced items, forcing Ford to compete at lower price points.

Probability of Another Rate Hike

The Fed will have two more job reports and two CPI reports to review before its September report. If the data warranted it, it would increase rates at that time. Conversely, favorable data would justify not raising rates in two months.

At that upcoming meeting, chances are high that it will pause raising rates. When Fed Chair Jerome Powell said that, markets responded positively almost immediately at 2:40 p.m.:

Buy Bonds

Battered investors from last year (2022) would need to pay for the 18.8% year-to-date gains on the S&P 500. By chasing the rally, this group risks losing more by buying at a potential peak. Priced for a soft landing, cautious investors may consider the bond market instead. They may interpret Powell’s rate pause by shopping for treasury bonds. As yields fall, bond prices rise.

The next two CPI reports will have a positive impact on consumers if they indicate that inflation is slowing. Consumers typically react to the drop in those headline inflation reports by spending confidently. A lower CPI report would increase bond prices.

The core inflation, which excludes food and energy, remains reasonably elevated. This justifies the Fed’s current restrictive policy. To maximize bond yields, debt investors may buy treasury bonds in the one to 12-month term. Still, the 30-year bond, through the ETF ( TLT ), offers the most capital gain upside if rates do not rise at the next meeting.

Since investors have no way of predicting upcoming CPI and job growth, TLT still has downside risks.

S&P 500 Target

Buying momentum in the S&P 500 may send the index to the 4,700 highs not seen since 2021. Now that the pace of rate hikes is slowing, chances are low that sentiment would reverse to send the index to the 3,840 – 4,240 support levels (based on technical charts).

Investors would fare better at long-term investing by ignoring index targets (despite my attempt above). Howard Marks encouraged readers to develop a long-term investing thesis instead of worrying about buying at the top or selling at the bottom .

Risks

The Fed’s monetary policy may have little impact on global inflationary forces. More recently, copper and other base metal prices rose after China pledged to increase policy to support its economy. The stronger domestic demand in China could potentially lift U.S. inflation levels. This is due to higher LME aluminum ( LMAHDS03:COM ) prices, copper ( HG1:COM ), and oil prices.

The persistent inflation would require the Fed to keep rates at current levels. This would strengthen the dollar ( DXY ), minimizing the impact of importing inflation from higher commodity prices.

Your Takeaway

Markets seem too complacent. They appear to price a perfect scenario of a soft landing. Admittedly, a cyclical slowdown in economic growth that avoids a recession is possible, thanks to a resilient job market and the fall in CPI. However, risks are rising that markets expect no unknowns ahead. Moreover, the issue is that 2.0% inflation is not achievable until 2025 at the earliest.

Companies would need to post profit growth in the next six quarters. Unfortunately, markets leave no room for external, unknown crises at that time that would hurt company profitability.

Immediately after Chair Powell indicated no rate cuts and expectations of elevated inflation, the indices gave up their gains. Traders welcome this volatility while long-term investors may start considering bonds to diversify from stock holdings.

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