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Last week’s daily stock-market fluctuations, which included both the highest daily gain and daily fall of the year, may have seemed like something new was afoot in a year that has seen plenty of volatility. We wouldn’t classify this as “much ado about nothing,” but we don’t believe it should be read as a symptom of a new market danger or narrative. Instead, we believe that this volatility is a consequence of the market’s inability to predict the result of the Fed’s tightening and a still-viable growth.
Inflation is high, but recent patterns show that it has peaked and is gradually declining.
The Fed has completed the first of many substantial (0.50 percent) rate rises, but it does not intend to pursue bigger (0.75 percent) raises or a more aggressive rate tightening pace.
Ongoing supply disruptions from China’s lockdowns, as well as rising consumer costs worsened by high oil prices, represent challenges for the economy, while consumer employment circumstances remain solid.
Corporate earnings are not immune to growing costs, but strong profits continue to be a pillar of support.
The stock market downturn is still ongoing, with technology under pressure as valuations are repriced for rising interest rates.
Just said, although significant market swings may seem to indicate heightened uncertainty, events and data this week simply reaffirmed what we already knew: the Fed will continue to tighten, and the economy is still in reasonable (but not flawless) form. Here are four major things we learned about the future last week:
Last Monday, the Fed hiked interest rates by 50 basis points (0.50 percent), the first increase of more than 0.25 percent in 22 years. We believe the most important lesson from the meeting was that the Fed is determined to pursue vigorous policy tightening in the coming months in order to catch up with the inflation curve. We believe the next two meetings will also include 50-basis-point rate rises, as well as an aggressive strategy to shrink the Fed’s balance sheet.
Simultaneously, Fed Chair Powell hinted that monetary officials are not yet willing to increase their boldness with more rate rises. We think the Fed recognizes the necessity to continue tightening despite the possible negative impact on the economy. However, we believe that the Fed still sees a window of tightening that is adequate to drive inflation down but not purposefully and totally snuffing out the boom.
In order to combat chronic and extremely high inflation, the Fed purposely put the economy back into recession in 1980. It accomplished it by increasing the federal funds rate from 10% to 22%. In instance, 1994 saw a vigorous tightening period in which the Fed raised its policy rate from 3% to 6% in nearly a year without causing an economic downturn. The market presently anticipates a 2.5 percent rise in the federal funds rate this year.
To create confidence in battling inflation, we believe the Fed will need to maintain its commitment to consistent rate rises in the coming months. If this is not done, inflation expectations may become unbalanced. We believe that this will come at the price of economic vitality and financial-market exuberance, but we still see a plausible case for a “soft landing.” There are significant distinctions now, yet 1994 and 2018 are both plausible scenarios. We believe last week’s Fed statement confirms our view that the central bank would be proactive in the beginning in order to build room for greater flexibility later in the year when the effects of first tightening are examined.
The economy is weakening due to a number of reasons, including the fading boost from last year’s stimulus payments, increasing consumer prices, which are lowering real earnings and consumption, and persisting supply constraints. The current sell-off, along with the response to the Fed meeting last week, seems to be pricing in a mainstream belief that a recession is near. We do not disregard these dangers. Our economic-cycle model, in fact, verifies several late-cycle traits. One sector to watch is housing, which we believe will be most affected by the Fed’s activities. We’ve already seen a reduction in mortgage applications as interest rates have risen, and we anticipate the pace of housing-price growth to slow from the recent high (which, by the way, would have the silver lining of reduced inflation pressures stemming from rising shelter costs).
Having said that, there is still plenty of evidence that the growth can continue despite the Fed’s strong headwinds. The labor market, in particular, remains a source of hope as the most important generator of economic growth. The employment report released last week showed a 428,000 rise in payrolls in April, matching the gains of the previous month and extending the record of monthly job growth over 400,000 to 12 months. The unemployment rate remained stable at 3.6 percent, only a little higher than the half-century low.
We realize that the consequences of Fed tightening have yet to completely permeate the economy, but we believe the implications of a solid labor market should not be dismissed, as seems to be the case at the present. Looking back at the recessions that started in 1980, 1990, 2001, and 2007, the unemployment rate bottomed out 13 months before the recession started. Furthermore, before each of those recessions started, the unemployment rate climbed by at least 0.5 percent (and an average of 0.6 percent). We believe that present unemployment has capacity to fall further, but that an increase in the jobless rate is required for an impending recession. While this is not impossible, we believe labor market tightness will continue this year, helping to offset the downturn in other sectors of the economy.
The simultaneous losses in equities and bonds have been one of the market’s most notable features. Bond investors are concerned that the year-to-date falls are just the beginning. This is not our point of view. There’s no doubt that fixed-income returns have been extraordinary and unpleasant, but the yield curve is clearly pricing in big Fed rate rises this year. To the extent that the Fed does not need to considerably increase its rate-hike plans beyond current expectations (which will need inflation to begin to decrease shortly), we do not believe interest rates need to rise much further from here.
Yields have traditionally peaked just before the end of the Fed rate-hiking cycle. Given the trend of increasing openness and communication around Fed policy in comparison to previous cycles, we believe rates will peak ahead of previous experiences. As a result, we believe we are nearing the top rather than the bottom. Longer-term rates may have more potential to rise given the Fed’s planned balance-sheet reduction, but our research implies that 3.5 percent might mark a top for 10-year Treasury yields. Nonetheless, although we predict more mild swings in yields as we go, we don’t see interest rates dropping much until the Fed’s rate rises come to a conclusion.
The Fed is unlikely to alter direction in the short future, which means bonds are unlikely to recover immediately. This is not to say that bonds should be avoided right now. Here are three explanations for this:
While we believe longer-term rates have the ability to rise moderately, we believe
the bulk of the increase has already happened. As a result, we believe that the
majority of the suffering in bond returns has already occurred. Bond-coupon payments
would continue to be paid in the absence of further rise in interest rates, and bond
values would naturally move upward toward par as maturity approaches. Short-term
bond losses, in other words, do not have to be recurrent or permanent.
While fixed-income returns have lately gone in the same direction as equity returns, bonds continue to have a low correlation to equities, bolstering their diversification advantages in portfolios. Bonds have surged during recent stock sell-offs, showing that they still provide some potential downside protection for portfolios despite the background of Fed rate rises.
Yields are higher than they’ve been in a long time, providing some possible chances inside fixed-income positions to pick up some yield in short-term Treasury and municipal bonds, as well as CDs and investment-grade corporate bonds.
A peek at last week’s daily market movements may give the impression that volatility has entered uncharted terrain. The Dow gained 900 points on Wednesday before dropping 1000 points the following day. Within the previous six trading days, the S&P 500 has suffered three of its greatest daily swings of the year, while the Nasdaq has had its worst daily decline since June 2020. This may seem to be gloomy and unusual, but large daily swings are not solely a reflection of oncoming bear markets. So far this year, the S&P 500 has dropped 3% or more on two occasions. Five such days occurred in 2018, two in 2015, six in 2011, and five in 2010. In contrast, the bear market years of 2008, 2009, and 2020 witnessed an average of 17 days of 3% declines.
The stock market has fallen as much as 14% from its high in January, matching the average peak-to-bottom decrease for previous non recessionary corrections. There have been two declared bear markets (20 percent or more falls) that have not been followed by a recession in the previous 60 years (1966 and 1987), with an average decrease of 28 percent . While we cannot rule out more equity weakness as this inflationary and Fed policy phase plays out, history may give some solace that, in the absence of a full-fledged economic slump, the present retreat may have already absorbed most of the downside.
The stock market’s correction has almost entirely been caused by a drop in valuations, as equities have been rapidly repriced for a higher-interest-rate environment. In 2022, the future price-to-earnings (P/E) ratio has fallen by 21%. Prior Fed tightening cycles were followed by a 20% drop in P/E ratios. This indicates that stocks are already reflecting Fed headwinds and a pretty high risk of recession, which provides some reassurance that a significant degree of pessimism and possibly negative consequences are already priced in.
The present atmosphere is strikingly comparable to the Fed tightening stages of 1994 and 2018, when markets were more concerned that monetary policy had become too restrictive. Stocks fell 8.9 percent in 1994 and 19.8 percent in late 2018, before recovering 5.2 percent and 25.3 percent during the next six months. Both of these recoveries were triggered by the Fed pausing its rate-hiking initiatives. This is consistent with our present belief that a move in Fed expectations will be a required trigger for a longer-lasting adjustment in the market’s current attitude. We do not believe that stocks must continue to fall in the meantime. However, we believe that a slowing in inflationary pressures will be enough of a signal to the market that the required amount of forthcoming Fed tightening has already been priced in. This, we believe, will be the driver for additional spectacular gains in stocks this year.