The Fed seems clear: Control inflation at the expense of growth
Following the largest rate hike since 1994, we share five observations on a critical week for markets.
Our Top Market Takeaways for June 17, 2022
Markets in a minute
Highway to the danger zone
This week, the Federal Reserve raised policy rates by 75 bps, which they haven’t done since 1994.
Their message seems clear: they are solely focused on containing inflation, and they are willing to harm growth to do it. Many investors are now assuming that a recession is necessary to cure the inflation problem. It shouldn’t be surprising, then, that global assets have sold off aggressively since last Friday.
U.S. stocks are down almost 8% since U.S. headline consumer price data was released last Friday, which has wiped out all the gains made since the end of 2020. Bond yields across the curve have soared. U.S. 10-year yields started the week at 3% and reached 3.5% for the first time since 2011, before coming back down to ~3.2%. The market now expects the Federal Funds rate to peak at almost 4% by the spring of next year.
What to make of it all? Our strategists hosted a webcast yesterday where they discussed the Fed meeting along with several other dynamics driving global markets and offered several steps to help maintain discipline through discomfort. We encourage watching the replay and exploring our Mid-Year Outlook.
In the rest of today’s note, we offer five observations that illustrate what has been a critical week for markets.
1. The Fed is willing to harm growth to control inflation. They expect policy rates to be more restrictive, and they expect below trend growth. On the labor market, their 2024 projection for the unemployment rate is 4.1% vs. 3.6% today, which, assuming a constant labor force, implies about 800,000 fewer people on payrolls. This projection is buzzing the tower of recession. Importantly, economic data and corporate anecdotes from this week suggested an environment of already weakening activity. Retail sales for the control group came in effectively flat in the month of May, while housing starts collapsed by over 14%. Pending home sales in California over 30% in May. Companies such as Tesla, Coinbase, Redfin, Compass Real Estate, Warner Brothers and Spotify have already announced layoffs or hiring freezes this week.
2. Prices at the pump matter. Markets were expecting a 50 bps move until a suspiciously well-sourced Wall Street Journal article published on Monday strongly hinted that it would be 75 bps. Why the switch? Powell suggested that the most recent CPI data, and, perhaps more importantly, the University of Michigan inflation expectations survey from last Friday, forced them into a more aggressive action. The problem is that both data points were heavily influenced by higher oil prices. Gasoline accounted for 20% of the monthly change in the CPI index, and the University of Michigan survey has an uncanny correlation with prices at the pump. Lower oil prices may be the quickest way to fewer rate hikes, while further gains could mean a more aggressive Fed.
3. Tightening is a global phenomenon. Just this week, central banks in the United Kingdom, Switzerland, Taiwan, Brazil and Hungary raised interest rates. The European Central Bank seems set to raise rates later this summer, but their plans are being complicated by emerging stress in peripheral member states (namely Italy). There are even growing questions about the sustainability of the Bank of Japan’s yield curve control program. During the last cycle, investors could count on global central banks to pin policy rates at ultra-low levels, which reduced volatility across asset classes. Now that central banks are being forced to respond to inflation, volatility seems set to remain elevated at levels more akin to the early 2000s than the mid-2010s.
4. Stock markets are under pressure. The S&P 500 officially entered bear market territory this week and currently trades about 25% below its all-time high. Only seven stocks in the S&P 500 are within 10% of their 52-week highs, and only 12 of the 47 countries we track have positive performance this year. Within the S&P 500, several sectors are approaching drawdowns that could be described as recessionary. The consumer discretionary sector’s 33% drawdown has erased all gains made during the pandemic era and is commensurate with that seen during the last four recessions. We probably aren’t there yet, but the equity market is getting closer to reflecting a slowdown in economic growth that would be deeper than we think is likely, given solid corporate and financial sector balance sheets and a resilient, if strained, consumer.
5. Discipline through discomfort. Bear markets can be painful, but enduring them is critical for long-term investment success. The chart below shows S&P 500 drawdowns since 1970. The only periods when the market was down 10% or more one year after stocks had already entered a bear market were from November 1973-April 1974, June 2001-June 2002 and July 2008-September 2008. Similarly, historical forward returns over three-, six-, 12- and 24-month periods have been higher if the starting point is during a bear market than it is on any random day. The only good thing about bear markets is that they tend to turn into bull markets (eventually).
Before we get too despondent, there is still a decent case for a more positive path forward. Discounting could make a major comeback this summer given elevated retailer inventories, and shipping rates are about to decline on a year-over-year basis. That should help lower goods inflation even further. Wage growth is already slowing, reducing the risk of a wage-price spiral.
The pandemic era imbalances in the digital economy are unwinding rapidly, all while incomes maintain spending on services. Equity markets are historically oversold and will likely be higher in a year than they are today, even if we haven’t reached the bottom yet.
In our Mid-Year Outlook, we made three suggestions on how investors can navigate this uncomfortable environment. First, core fixed income yields are implying compelling returns on a go-forward basis and would likely provide protection if a recession does come to pass. Next, quality equities should outperform as the Fed continues to campaign against inflation. Finally, we think there are compelling opportunities to position for structural change through this cycle and next. Perhaps most importantly, investors should discuss what the outlook might mean in the context of their own plan with their JPMorgan team.