In 1955, then Federal Reserve Chairman William McChesney Martin explained that one of the functions of the Fed was to order “the withdrawal of the punch bowl just when the party is really heating up.”” Jay Powell, the current president, has taken this teaching to heart. After saying a few weeks ago that the time had come to stop calling inflation “transient,” he went on to announce that the Fed would cut cash injections via bond purchases much faster than foreseen. The market believes it will end all buying by next March, when the Fed will also begin to hike rates. Right now, the consensus is that it will do it three times before the end of 2022.
A greedier Fed isn’t something the market generally likes, but the highest inflation readings in decades leaves the central bank with little or no choice, as it has to show it does its job. However, it is far from clear that higher rates would have an impact on containing inflation if the reason for the price hikes were the well-known crisis in global supply chains.
No Fed tightening will eliminate standby ships, production shutdowns in Southeast Asia, or a shortage of truck drivers, unless it hikes rates beyond expectations and cuts the rate. demand to such an extent that the shortages will no longer matter. It’s not impossible: the market is aware that the Fed has exaggerated past tightening and may do so again.
Rates and inflation are only a partial list of concerns. Omicron, the new variant of Covid-19, is also weighing on sentiment as it triggers a new round of preventative restrictions in Europe and the UK that could impact their economic recovery. The variant is also spreading rapidly in the United States, just as some economic indicators such as regional activity indices or retail sales are showing signs of slowing down. No one is quite sure how the ever-changing and never-ending pandemic could affect conditions in the months to come, which is bad news for a market that places great importance on certainty.
Does all of this mean that the 10+ year bull market is over? The optimistic view is that the job market remains strong, the consumer is still in good shape, and companies have maintained healthy earnings despite supply chain disruptions. Early indications here and there that these may be easing have led some to believe that once resolved, the pendulum will tip into excess supply caused by the acceleration in production and inflation will drop very quickly. Considering how the pandemic has beaten all predictions, this is as plausible as anything else.
Market dynamics, however, point to a worsening outlook for equities. First, the volatility indices of the Nasdaq 100 and the S&P 500 rose in early December and remain volatile. Volatility indices reflect the cost of insuring a portfolio of stocks, which is why they are often referred to as âfear indicesâ – the more you fear that a stock will fall, the more you are willing to pay for insurance.
Second, the yield difference between 10-year and 2-year US Treasuries is less than 0.8%, half of what it was in the first quarter after shrinking rapidly in recent weeks. The reason this is concerning is that this difference reflects the perspective of market participants on the economic outlook: the narrower the outlook, the weaker the outlook. The rare occasions when it turned negative were followed a few quarters later by recessions. It is still far from negative, but the rapid decline suggests that the market is quickly becoming convinced that the economy will slow down.
Finally, as we wrote not too long ago, stocks seem expensive. Sometimes this is seen as an oddity in the overall index (the S&P 500). Because constituent stocks are weighted by market cap, the reasoning goes, large, high-flying stocks like Amazon
This argument does not really hold up. There is an index that assigns the same weight to every stock, large or small, in the S&P 500. Although the market cap index (the S&P 500) seems slightly ahead of the equal weight index in recent months, it It’s hard to argue that the big stock effect is really in play when the clues are plotted together. Either way, the equity market is at the top of its historic trend band.
While all of this is not enough to conclude that stocks are on the verge of crashing, there is no doubt that the economy and markets are more fragile and the near-term outlook much less bright than there is. just a few months away. We are still going through the aftermath of the pandemic trying to understand its impact on everything. Few, if any, predicted labor shortages, supply disruptions, and the 180-degree turn from an accommodating Fed to a hawkish Fed.
Add to this the skyrocketing global public debt, a resurgence of populism everywhere, renewed geopolitical tensions and much more and it becomes clear that forecasting markets or economic conditions has rarely been so difficult. By definition, this means that much of what happens over the next few quarters risks hitting investors unprepared. Short-term volatility therefore seems inevitable.
Investors who do not have a long term horizon or who cannot tolerate volatility may be well served by reducing the risk exposure of their portfolios. Stocks have been in a bull market for a long time, are still close to their all-time high, and the more aggressive stocks have been the biggest winners. This looks like a great opportunity to take profit and explore more defensive and lagging areas like consumer staples or healthcare until the outlook becomes clearer.
Of course, there could be an opportunity cost if the markets continue at the same scorching pace it has seen since the trough of the pandemic, so some investors will rush forward for fear of leaving gains on the table. Wall Street elders will argue that pigs get fat but pigs are slaughtered.