Weekly Investment Update (11/03/2023)

This Week’s Positioning and Views

In recent months, we have highlighted that investors would need to see additional evidence of slower economic growth to bolster confidence that the Federal Reserve would end its rate hiking cycle. We believed this would lead to a reversal in stock market weakness, which has largely been driven by valuation multiple compression as interest rates moved decidedly higher.

This week, we received a series of economic data points that support the notion that, although third quarter GDP was much stronger than many had anticipated, growth is in fact slowing —Manufacturing PMI, ADP employment, unemployment claims, and the nonfarm payroll report (more detail below) all came in below expectations. As a result, the 10-year Treasury yield has fallen from 4.98% to 4.55% over the past two weeks while the S&P 500 index has rallied 5% from recent lows. An immediate recession seems unlikely, but there appears to be enough evidence of economic softness for the Federal Reserve to sit on the sidelines. This remains a delicate balance, but we expect equity markets to continue to respond positively to data that keeps the Fed dormant. Given our expectations for incremental economic weakness ahead, an overweight to stocks remains appropriate as the market continues to search for confirmation of a peak in rates.

Fed Holds Rates Steady, Labor Market Loosens

What is happening: For the second consecutive meeting, the Federal Reserve left the federal funds rate unchanged at 5.25%-5.50%. Fed Chair Powell reiterated the recent tightening in financial conditions, highlighting that tighter conditions have an impact on the path of monetary policy. The Federal Reserve upgraded its assessment of economic activity, and Powell noted that FOMC members did not put a recession back into baseline forecasts. While a recession is not the Fed’s base case , labor market loosening is beginning to materialize. The unemployment rate rose to 3.9%, and the pace of job gains and wage growth came in below expectations. The weakness in October was paired with 101K of negative revisions to job growth over the prior two months.

Why It matters: We expect investor focus to shift from the height of the fed funds rate ceiling to the length with which it is kept elevated. The Fed’s acknowledgement of the tightening in financial conditions is likely more dovish than investors appreciate. Although the door was left open for more hikes, the Federal Reserve is likely done with interest rate hikes, in our view.

Softer economic data — specifically signs of a loosening labor market — should allow the Federal Reserve to hold rates steady, allowing the impact of higher rates to further permeate the economy. The pace of job gains over the last three months has averaged 204K, a slowdown from the last 12, where job gains have averaged 243K. The slowing pace, among other indicators, leads us to expect a continued loosening within the labor market. Investors have moved up their expectations for rate cuts to June from July prior to the report , and yields have come off their highs.

ISM Manufacturing Sentiment Dips After Three Consecutive Increases

What is happening: The ISM Manufacturing Purchasing Managers’ Index (PMI) survey was weaker than expected in October, falling to 46.7 from 49.0 in September and below consensus estimates of 49.0. October marked the first month the ISM manufacturing PMI declined after consistently moving higher since June. The ISM manufacturing index has now remained in contraction for one year. Respondents to the ISM survey noted a slowing economy, and this weaker demand was reflected in the ISM’s New Orders Index, which fell to 45.5 from 49.2 the month prior.

Why it matters: Historically, the ISM Manufacturing PMI has had a close correlation with S&P 500 forward earnings as it tends to be a gauge for the business cycle given its cyclical nature. While one downward data point does not make a trend, as higher interest rates continue to permeate the economy, there could be additional pressure on the manufacturing sector and, in turn, future S&P 500 earnings. Though recent U.S. industrial policy, including the Inflation Reduction Act and the CHIPSs Act, should provide a boost to domestic manufacturing, it is unlikely to fully offset the impact of higher interest rates on the economy.

Given our expectation for slowing in economic growth, Bessemer’s All Equity Portfolio maintains its tilt away from cyclical oriented sectors. While the All Equity Portfolio is overweight the industrial sector, it is exposed to companies that we believe should be beneficiaries from government funded programs. For example, Bessemer holding Caterpillar noted on its recent call that “its non-residential construction segment continued to benefit from government-related infrastructure and construction projects.”