Home Deep Analysis Selling Stocks: The Fed Will ‘Walk’

Selling Stocks: The Fed Will ‘Walk’

by WOOWinvest
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Bearish S&P 500

Here’s a historical fact: Since 1945, the Fed has had 13 rate hike cycles—10 of 13 followed by recessions. Exceptions: 1994-95, 1983-84, 1965-66.

i explained Detail why the Fed can’t design a soft landing this time, as it did in 1995. To sum up: Inflation was never a problem during 1993-1995 because globalization was deflationary and made a soft landing possible. The current trend accelerating deglobalization is stagflation, making a soft landing nearly impossible.

The Fed is currently signaling very aggressive monetary policy tightening, which I think will lead to recessions and bear markets, just like 10 other historical cycles. This is a bearish (SP500) (SPY) thesis. However, when making stock market predictions (and acting on them), it is absolutely necessary to understand the counter-argument — the bullish thesis.

Counter argument – bullish argument

I closely follow research from major financial institutions and find BlackRock’s most coherent bullish thesis on U.S. stocks. Here are the latest comments from April 18:

BlackRock – Weekly Market Review: Strategic (Long-Term) and Tactical (6-12 Months) Views on Broad Asset Classes, April 18, 2022.

A directional view on stocks (BlackRock):

We overweight strategic stocks in the early 2022 sell-off. We see an opportunity for long-term investors in equities thanks to a combination of low real interest rates, strong growth and valuation changes. Given that sectors such as technology and healthcare are heavily weighted in the benchmark index, including climate change in our expected returns increases the attractiveness of developed market equities. Strategically, we prefer developed market equities over emerging market equities, and prefer the US and Japan to Europe.

Tactical view on U.S. stocks (BlackRock):

With earnings momentum remaining strong, we overweight U.S. equities. We don’t think the Fed has fully delivered on its hawkish rate forecast. We like the quality factor of the market because of its ability to adapt to a wide range of economic scenarios.

Essentially, BlackRock doesn’t believe the Fed will “walk,” despite the hawkish rhetoric. BlackRock believes the Fed will quickly raise interest rates to a neutral level, at which point above-target inflation will persist. In their view, we must all learn to live with higher inflation. Therefore, in this environment, equities are essentially the investment of choice, an effective hedge against inflation (both short-term and long-term). In other words, BlackRock believes in a soft landing scenario, with the Fed’s put options still solid. In their view, growth will remain strong and real interest rates will remain historically low. This is a bullish S&P 500 thesis.

Fed’s “Talk The Talk”

Federal Reserve Chairman Jerome Powell said at the International Monetary Fund on Thursday, April 20, 2022 that the central bank is committed to raising interest rates “rapidly” to reduce inflation. return,

“Restoration of price stability is absolutely necessary,”

“In my opinion, it’s appropriate to move faster”

“I also think the front-end loading of whatever accommodation people see fit has something to say…I would say 50 basis points will be discussed at the May meeting.”

These are extremely hawkish remarks that suggest very aggressive monetary policy tightening. As a result, Nomura Holdings now expects the Fed “to raise rates by 75 basis points at its June and July meetings, following an expected 50 basis point hike in May.” correct.

The credibility of the Fed

But will the Fed really follow these signals? Will the Fed “walk”? I firmly believe that yes, the Fed will have to implement the aggressive tightening it has issued to restore its credibility.

More specifically, on the same day that Fed Chairman Jerome Powell made these extremely hawkish remarks, long-term inflation expectations, represented by 10-year breakeven inflation expectations, exceeded 3%, the highest level on record.

So long-term inflation expectations are falling off their pegs as the Fed “walks the talk”, meaning the market doesn’t believe the Fed will actually “walk the talk” — in line with BlackRock’s argument. The Fed has no credibility to fight inflation – markets are used to believing that the Fed’s primary mission is to protect the stock market.

The problem is that, given the accelerating trend of deglobalization, inflationary pressures will persist – don’t expect a quick fix on the supply side. Runaway inflation can have very serious social and political consequences. As a result, the Fed will be forced to restore its credibility to re-anchor long-term inflation expectations, which can only be achieved by severely cutting demand — and with a shock to the stock market.

Influence

The S&P500 (SP500) is still overvalued with a ttm P/E around 24 and a forward P/E around 19. Market analysts such as BlackRock still expect the Fed to protect stocks primarily through Fed put options.

They don’t realize the game has changed. Fed puts are an effective tool in a deflationary environment when the Fed aims to boost demand through the wealth effect – rising stock markets boost confidence and demand through increased wealth.

But we are not in a deflationary environment right now – we are now facing an unanchored long-term inflation expectation against the backdrop of 40-year high CPI inflation. So the Fed doesn’t need a wealth effect right now. In fact, the Fed has to cut demand to fight inflation – falling asset prices would actually help.

As such, the S&P 500 is likely to enter a bear market since January 2022, with a long way to go – given only a modest 6-7% decline so far.

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