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Wealth Insights | Economy | Asset Allocation

There is Nothing to Fear but the Fed Itself

A swift correction is gripping equity markets. In just seven weeks, the S&P 500 has nearly hit bear market territory. The Dow’s eight-week decline is its longest streak since 1923. Thirty percent of Nasdaq-listed companies have lost half their value over the past 12 months. The decline in market value as of Friday is equal to about 60% of US GDP. The primary issue at the center of this $14 trillion evaporation in markets is inflation and the Fed’s pivot to fight it with urgency. It is an unusual bout of inflation arising from unusual circumstances. The pandemic, the (over)stimulus used to combat it, and the war in Ukraine are cumulatively distorting consumer and business demand, supply chains, and the availability of raw and finished goods.

As the S&P 500 approaches bear market territory, investors are looking to the Fed to see if it can engineer a “soft landing”, but to achieve a soft landing, the Fed would typically need to raise interest rates just enough to slow inflation in an overheated economy without causing a severe economic downturn.

  • And therein lies the stock market’s anxiety. The economy is slowing and the Fed is still taking its fastest and most aggressive rate stance in decades. The Fed’s recent actions have propelled a record, large combined drop in equities and fixed income markets, with both US stocks and long-term US Treasuries falling more than 10% in the last six months for the first time ever.

  • With the rapid market declines, several price/earnings measures for the S&P 500 P/E are approaching long-term averages. Normally, this would buoy markets. But CIO has recently revised S&P 500 EPS expectations downward. CIO’s estimates are 13% below analysts’ consensus “bottom up” projections for 2023 and suggest that EPS downward revisions are on the horizon. While these estimate reductions are short of recessionary and would leave 2022 full-year earnings growth at +5.5%, strong actual second-half earnings will be critical to achieving them.

Chart: Individual Investor Net Bullish Survey vs S&P 500

Portfolio Considerations

  • Indiscriminate selling could cause markets to plunge further. The average full-on bear market losses over the past 100 years have been 36% (peak-to-trough), and bear markets have lasted an average of 383 days. Recent contrarian indicators signal there may be stronger returns ahead. Poor investor sentiment, building demand for downside protection and spiking industry sector correlations all point to potentially stronger equity returns in the near term. That said, if the Fed does not heed the data, the likelihood of a recession becomes higher.

  • Citi Global Wealth is maintaining it conservative portfolio stance: The Global Investment Committee (GIC) left its asset allocation unchanged at its May meeting, with global equities overweight by 2% including a 4% inflation hedge position in global commodity producers. CIO has also added to long-duration bond positions, reflecting the primary view that the Fed will be unable to sustain higher rates for very long. CIO believes that there is a 70% probability that we are at or near peak rates for 2022.

  • Last month, the GIC raised long-duration US Treasuries to an overweight for the first time since yields bottomed in 2020. In CIO’s view, the positive correlation between high quality bonds and equities will break down, as has been evident in recent days as the equity selloff intensified. In CIO’s view, long-term government bonds should soon take comfort in a slowing growth outlook, and (with a lag) decelerating inflation. In the five previous cases of significant joint stock/bond losses during the past 60 years, long-term US Treasury returns were positive in all five cases.