Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Powell delivers early fireworks to markets
Peter Garnry
Chief Investment Strategist
Summary: Yesterday's US inflation report did nothing to stop the strong sentiment in equities setting markets up for a potential disappointment at tonight's FOMC press conference. US core services inflation has accelerated the past three months which might have spooked the Fed into doubling down on its message of higher for longer. If this is the case then equities will be great disappointed. After the US market close, Adobe will report earnings and investors are likely demanding that the company's generative AI product Firefly begin to move the needle on growth. If not, then it will be increasingly difficult to justify the current valuation.
The Fed buys into market narrative
Last night the FOMC bought into the recent market narrative pricing in rate cuts next year as inflation continues to cool, although in the short term US core services inflation remains high, forecasting three rate cuts next year compared to five cuts priced by the market (see price chart of SOFR Dec 2024 below). The message extended the rally in equities pushing Nasdaq 100 futures to a new all-time high on the close and the move has extended today with the index futures trading around the 16,850 level. It is not unrealistic to think that the S&P 500 could hit 5,000 in a complete melt-up scenario by yearend.
From a strategic perspective the Fed is happy with its policy forecast spread to market pricing on rate cuts as any error will force the market to correct first creating a buffer for policymakers. As such the Fed will likely continue to update its forecasts for rate cuts in tandem with market pricing keeping a certain spread in place with two rate cuts being the current spread. Some say that the market is getting too aggressive in its pricing but history is on the side of markets because when a rate cycle begins the policy rate trajectory often accelerates faster than most anticipate. This could easily happen again.
The logical narrative in the market is that the policy rate repricing drives the market through valuation expansion, but as our chart below shows there has been little logical connection between the market’s pricing of Fed policy rate Dec 2024 and the forward equity valuation of the S&P 500. In other words, if the repricing matters for equities is a local phenomenon and not a generalized dynamic. As we have been writing for quite some time, the market’s logic is this. As long as the policy rate is only projected to fall less than 200 bps then the interpretation is a soft landing meaning lowering discount rate on cash flow with stable nominal growth of 4-6%. This will support the positive momentum in equities, but if the policy rate pricing exceed the 200 bps then the equity market will begin realising that policy rate cuts are suddenly an expression of an incoming recession and then the market dynamic will flip upside down.
ECB cools market pricing on rate cuts
Today’s ECB rate decision was no surprise in the sense of policy rates remaining unchanged but the central bank reiterated its higher for longer message despite lowering its inflation forecasts for next year on core inflation to 2.7% from previously 2.9% in addition to lowering its Eurozone GDP forecast for 2024 to 0.8% from previously 1%. These new forecasts underscore the fragility of the Eurozone economy but also supports rate cuts next year although the market is today lowering the change in policy rate a bit. However, if the economy continues to be slow paced the market will likely resume its pricing of more aggressive rate cuts for next year. The current ECB policy rate pricing in Dec 2024 is 2.36% vs 4% deposit facility rate.
Pfizer shares are down 45% in 2023 as 2024 outlook disappoints
A terrible year for Pfizer got worse yesterday with shares falling another 7% extending this year’s decline to 45.6% as the company updated the market on its 2024 outlook. Pfizer is guiding revenue of $58.5-61.5bn vs est. $62.9bn. In addition, the company said it expects $4bn in cost savings next year, but the market was clearly weighing growth over profitability in the update. Pfizer’s lower market value has pushed its equity valuation to around 6.2% on the FY24 free cash flow yield and 7x on FY24 EV/EBITDA which is a significant discount to the S&P 500 which valued at 12x on EV/EBITDA. In that sense, Pfizer is now truly a value company, but it has likely also become the case for the patient investor as there are no near-term catalysts that can change sentiment except for falling bond yields.
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