Wealth Insights | Weekly Market Analysis | Economy | Asset Allocation
Weekly Market Analysis: The Squeeze Is On
Posted on3 Things to Know
Little Fires Everywhere
The Fed continued an “easy money” strategy through 2021, well after the major financial dislocations of the pandemic had abated. Now, with its rapid tightening in 2022, market stability is beginning to fray again.
The Fed’s Selective Data Syndrome
The September nonfarm payrolls data, released Friday, paints a rosy employment picture, implying that the Fed will need to continue to raise rates sharply to slow it down. CIO strongly suspects Quantitative Tightening will end with real US job losses, but until such an event occurs, the Fed will be working to raise capital costs of firms while sapping market liquidity.
Implication for Equities
The Fed’s determined actions and the continued resiliency of both inflation and US employment do not bode well for equity markets in the near term. US equity markets are already down 23% through Oct. 7. Furthermore, US equity markets have never bottomed before a recession has even begun.
Summary
The three consecutive 75-basis-point rate hikes are the Fed’s fastest hikes ever and the largest increases since 1980. The forward curve suggests a further 125bps to come. Comparable to highway accident data, higher speeds and larger rate hikes combine to increase the probability and magnitude of negative consequences.
The Fed is likely to sustain its hawkish measures to crush inflation with limited regard for the time it takes for its medicine to work, likely damaging some markets along the way.
Portfolio considerations
Dividend reinvestment is more than a powerful contributor to total equity returns. More than 2% per annum may be earned just by “checking the box” and reinvesting your dividends.
Source: Haver Analytics as of Oct 7, 2022. Past performance is no guarantee of future results. Real results will vary.
Little Fires Everywhere
This week, Mohamed El-Erian said it best. “We are living in a world with little fires everywhere. If we don’t pay attention, these little fires could become much bigger.” So it is in markets. The Fed continued an “easy money” strategy through 2021, well after the major financial dislocations of the pandemic abated. Now, with its rapid tightening in 2022, market stability is beginning to fray again. Illiquidity in the US Treasury market is evident. Treasury volatility is at its highest levels since the 2008 financial crisis, save for 2020. Meanwhile, investors have built large short positions in equities, bonds and non-US currencies, fueled by negative economic data, sentiment and the positioning of systematic traders, according to CFTC data. Troublesome macroeconomic news and strident policy statements drive sentiment down, yet large counter-trend rallies can occur. CIO believes these bear market rallies are head fakes that can mislead investors into believing a lasting new economic expansion is at hand. That’s not the case. All of this is evidenced by wide, volatile price ranges for many asset prices.
The Fed’s Selective Data Syndrome
Last week the US reported a 1.1 million drop in job openings, the largest monthly decline since COVID struck in 2020. That’s good data, but it can also be interpreted and ignored. The Fed could say that job openings remain high, pointing to the ratio of openings to job seekers, a misleading and perhaps irrelevant “fact” given the low cost and ease of posting job listings online. While the Fed would certainly pause or reverse course if the “core” financial system were threatened, it appears it’s willing to see asset prices fall considerably to achieve its inflation reduction goals. At his Sept. 19 FOMC meeting, Fed Chairman Powell said: “we probably in the housing market have to go through a correction.” That’s well underway with mortgage purchase application volumes down 45% in the year-to-date. A very sharp and rapid rise in mortgage rates this year appears set to sink home values in 2023.
Implication for Equities
By openly encouraging lower asset prices, whether in housing, equities or foreign currencies, the Fed is leading market participants to become extremely defensive. That defensiveness can not only reduce liquidity and increase volatility, but it can also change investors’ behavior and create negative feedback loops. The Fed’s determined actions and the continued resiliency of both inflation and US employment do not bode well for equity markets in the near term. US equity markets are already down 23% through Oct. 7. Furthermore, US equity markets have never bottomed before a recession has even begun.
Portfolio considerations
CIO expects the Fed to continue raising rates through the next 2-3 FOMC meetings, which in turn will likely lead to a greater frequency of small flare-ups across markets, stoking greater volatility. Ultimately, a fall in employment sometime in 2023 is likely to see the Fed suspend its fight against inflation. Importantly, the fruits of long-term economic growth can only be earned in time through patient exposure to innovative companies. So too, must one be patient as the economy works through a difficult period for inflation and monetary policy. There are many reasons why market timing is the wrong strategy in a period of high event risk. CIO believes it’s prudent to “mind the gap” by seeking to maintain an up-in-quality bias in both equities and fixed income. Even in poor markets and even if returns are mediocre in the interim, the direction of that gap can be up.
