What Can We Learn From Last Week’s Moves?

Last week’s daily stock-market fluctuations, which included both the highest daily gain and daily fall of the year, may have felt like something new in an already volatile year. We wouldn’t call this “much ado about nothing,” but we don’t believe it should be seen as a hint that a new market danger or narrative has emerged. Instead, we believe that this volatility is a consequence of the market’s continuous struggle to predict the result of the Fed’s tightening versus a still-viable expansion.

Here’s what we knew going into May:

  • Inflation has reached dangerously high levels.
  • The Federal Reserve is in the midst of a tightening campaign aimed at reducing inflationary pressures.
  • The economy’s foundations are generally stable, thanks to historically tight labour markets and strong consumer finances.
  • Corporate America is doing well, with profits set to increase at a healthy rate this year.
  • Stocks are under pressure as investors become increasingly concerned that the Federal Reserve may tip the country into recession.
  • Bonds are also under strain when interest rates rise sharply.

Here’s what we know about what happened last week:

  • Inflation is still high, but recent trends show that it has peaked and is steadily declining.
  • The Fed has completed the first of several major rate hikes (0.50 percent), but it has no plans to seek greater raises (0.75 percent) or a faster pace of tightening.
  • The economy is facing headwinds from ongoing supply disruptions resulting from China’s lockdowns, as well as rising consumer costs worsened by high oil prices, but consumer employment circumstances remain solid.
  • Although corporate profits are not immune to growing costs, they remain a strong foundation of support.
  • As valuations are repriced for higher rates, the stock market slump continues, putting pressure on technology.

Only said, while significant market swings may appear to indicate heightened uncertainty, last week’s events and data simply confirmed what we already knew: the Fed will continue to tighten, and the economy is still in reasonable (but not flawless) form. Here are four significant things we learned about the road ahead this week:

1. To prevent steering into the ditch, the Fed will keep its foot firmly on the brake

  • Last Monday, the Federal Reserve hiked interest rates by 50 basis points (0.50 percent), the first increase of more than 0.25 percent in 22 years1. The most important message from the meeting, in our opinion, is that the Fed is determined to pursuing vigorous policy tightening in the coming months in order to catch up with the inflation curve. We believe the Fed will raise rates by 50 basis points at its next two sessions, as well as take an active strategy to shrinking its balance sheet.
  • At the same time, Fed Chair Powell indicated that monetary authorities are unlikely to increase their boldness with additional rate hikes. We believe the Fed recognises the necessity to continue tightening despite the possible negative consequences for the economy. However, this signals to us that the Fed still sees a window of tightening that is sufficient to drive inflation down without suffocating the boom totally.
  • In 1980, the Federal Reserve purposely pushed the economy back into recession in order to combat chronically rising inflation. It accomplished it by increasing the federal funds rate from 10% to 22% 1. In 1994, the Fed raised its policy rate from 3% to 6% in a year’s time without causing an economic downturn1. The fed funds rate is expected to rise by around 2.5 percent this year, according to the market.
  • To create confidence in managing inflation, we believe the Fed will need to stick to gradual rate hikes in the coming months. If this is not done, inflation expectations may become unbalanced. We believe this will come at the expense of economic vitality and financial-market exuberance, but we believe there is still a case for a “soft landing.” Today, there are significant distinctions, but 1994 and 2018 are both plausible scenarios. We believe the Fed’s announcement last week confirms our belief that the central bank will take a more aggressive stance up front in order to free up more flexibility later in the year when the effects of first tightening are examined.

2. The stock market is pricing in a downturn. We believe the dangers are increasing, but a recession is far from certain.

  • The economy is weakening as a result of a number of factors, including the fading stimulus boost from last year, rising consumer prices, which are lowering real income and spending, and persisting supply constraints. Along with last week’s reaction to the Fed meeting, the recent decline looks to be pricing in a mainstream belief that a recession is on the way. These dangers are not dismissed. In fact, some late-cycle traits are confirmed by our economic-cycle model. One sector to watch is housing, which we believe will be hit hard by the Fed’s measures. We’ve already observed a decline in mortgage applications as rates have risen, and we expect the trend to continue. which we believe the Fed’s policies will have a significant influence on. We’ve already seen a reduction in mortgage applications as rates have risen, and we expect housing price rises to slow down from their recent highs (which, by the way, would have the silver lining of reduced inflation pressures stemming from rising shelter costs).
  • Despite this, there is still plenty of evidence that the expansion can continue despite the Fed’s strong headwinds. The labour market, in particular, remains a source of hope as the most important generator of economic growth. The jobs report released last week showed a 428,000 increase in payrolls in April, matching the prior month’s gains and extending the streak of monthly job growth above 400,000. over a period of 12 months. The jobless rate remained unchanged at 3.6 percent, just a smidgeon over the 50-year low.
  • We acknowledge that the impacts of Fed tightening haven’t yet fully pervaded the economy, but we don’t believe the implications of a strong labour market should be dismissed, as they appear to be at the moment. Looking back at the recessions that started in 1980, 1990, 2001, and 2007, the jobless rate peaked 13 months before the recession began on average. Furthermore, each of those recessions began with an increase in the unemployment rate of at least 0.5 percent (and an average of 0.6 percent). We believe that present unemployment has room to fall further, but that an increase in the unemployment rate would be undesirable. a need in the event of a future recession While not impossible, we believe labour market tightness will persist this year, helping to offset downturn in other areas of the economy.

3. The majority of the rising-rate road has been traversed, but not all of it.

  • The simultaneous falls in stocks and bonds have been one of the most unusual characteristics of this market correction. This has caused bond investors to be concerned that the year-to-date losses are only the beginning. This is not our point of view. There’s no doubting that fixed-income returns have been extraordinary and painful, but the yield curve is clearly pricing in big Fed rate hikes this year. We don’t believe interest rates need to rise dramatically further from here if the Fed doesn’t have to raise rates significantly beyond current expectations (which would require inflation to begin to decrease shortly).
  • It’s doubtful that the Fed would reverse direction in the near future, so we don’t expect bonds to recover quickly. This is not to say that bonds should be avoided at this time. The following are three reasons why:
  • While we believe longer-term rates have the ability to rise moderately, we believe the majority of the increase has already occurred. As a result, we believe that most of the bond market’s agony has already passed. Bond-coupon payments would still be made in the absence of another interest rate hike, and bond prices would naturally move upward toward par as maturity approaches, absent a credit event or default. Short-term bond losses, in other words, do not have to be recurrent or permanent.
  • While fixed-income returns have recently gone in the same direction as stock returns, bonds nevertheless have a low correlation to equities, allowing for portfolio diversification. Bonds have gained during recent stocks sell-offs, indicating that, despite the backdrop of Fed rate hikes, they still offer some potential downside protection for portfolios.
  • Short-term Treasury and municipal bonds, as well as CDs and investment-grade corporate bonds, are yielding more than they have in a long time, giving some potential possibilities within fixed-income positions to pick up some yield.

4. The stock market may not be as nimble as it once was, but now is not the time to give up.

Last week’s daily market movements may create the impression that volatility has reached unprecedented heights. The Dow gained 900 points on Wednesday before dropping 1000 points the next day1. Within the last six trading days, the S&P 500 has had its three greatest daily swings of the year, while the Nasdaq has seen its worst daily decline since June 20201. This may appear ominous and unusual, but large daily fluctuations are not always indicative of imminent bear markets. So far this year, the S&P 500 has dropped 3% or more on two separate days1. In 2018, five such days occurred, compared to two in 2015, six in 2011, and five in 20101. In comparison, the bear market years of 2008, 2009, and 2020 witnessed an average of 17 days of falls of 3%1.

The stock market has dropped as much as 14% since its January peak, matching the average peak-to-bottom decline for nonrecessionary declines in the past1. There have been two formal bear markets (20 percent or more falls) without a recession in the last 60 years (1966 and 1987), with an average decrease of 28 percent. 1. While we can’t rule out further stocks weakness as this inflationary and Fed policy period unfolds, history suggests that, without a full-fledged economic slump, the present retreat may have already occurred.

Much of the disadvantage was captured.

The stock market’s correction has almost entirely been caused by a drop in valuations, as equities have been repriced for a higher-interest-rate environment. In 20221, the future price-to-earnings (P/E) ratio has declined by 21%. Prior Fed tightening cycles were followed by a 20 percent average P/E decline. This indicates that markets are already reflecting Fed headwinds and a high risk of recession, providing some solace in the knowledge that a substantial amount of pessimism and possibly negative outcomes have already been priced in.

The current situation is strikingly similar to the Fed’s tightening stages in 1994 and 2018, when markets became more concerned that monetary policy had become excessively restrictive. Stocks fell 8.9% in 1994 and 19.8% in late 2018, respectively, before rebounding 5.2 percent and 25.3 percent during the next six months1. The Fed’s decision to suspend its rate-hiking efforts prompted each of these recoveries. This is consistent with our present belief that a move in Fed expectations will be a required catalyst for a longer-term adjustment in market sentiment. In the meanwhile, we don’t believe equities need to continue to drop. However, we believe that a reduction in inflationary pressures will be the catalyst for sufficient confidence.

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