United States Federal Reserve Bank building on Constitution Avenue. WASHINGTON, DC USA https://www.shutterstock.com/g/doganmesut
Investing Pioneer – 4:21 PM EST – 11/28/2022
Despite comments from Fed officials indicating continued tightening is likely necessary, and will be pursued to bring inflation down, equity markets have rallied significantly since the start of October. For example, the SPY ETF index has risen approximately 11% in the last two months from ~$357 to ~$400, following the marked ~17% drawdown at the end of summer/beginning of fall.
This latest bear market rally may have been in part fueled by a perceived shift that the Federal Reserve would begin to slow the rate and extent of rate hikes in the future, in part to diminish the risk of “over-tightening”.
A month ago, Ian Shepherdson, economist at Pantheon Macroeconomics wrote that,
“We see a decent chance that core inflation and wage growth will slow at the same time, more or less, making it much more likely that the Fed’s final hike will be in December.”
It is this thesis that seems to be attached to this latest rally.
A little over two weeks ago, the CPI report for October was released, indicating a 7.7% year-over-year rise, 0.2% less than the 7.9% consensus estimate.
For the active investor of $SPY or correlated securities, two main or key high-level questions arise.
- Will a Fed Pivot or slight easing occur in the foreseeable future, affording a commensurate rise in equity prices?
2. Could this shift occur in the short term?
This week is relatively significant in terms of catalysts, with the PCE inflation report on Thursday (said to be a more important indicator than the CPI for the Fed), and Jerome Powell set to speak on Wednesday. The S&P 500 is starting off the week red, down 1.52% on the day as of 2:41 PM EST (Monday, November 28th, 2022).
This follows Federal Reserve Bank of St. Louis President James Bullard saying the markets are underestimating the chances of higher rates. As well, he noted the Fed may have to keep rates higher into 2024.
With inflation as the main indicator for the Fed, any sort of pivot, signaling or action, which the markets would take as bullish (reflected in a rise in share price), may be unlikely in the near term. Rather, the Fed will likely continue the stance that they must continue tightening until there is evidence inflation is tangibly and durably down. Whether that will remain their stance can be questioned.
The Dow Jones Index has led this latest rally, with the Nasdaq somewhat faltering behind. Some say this is due to a growing number of investors seeking shelter in more defensive/value securities.
Though having reached the general support line/low of ~20 (for this year), the VIX (volatility index) spiked (as of 3:02 PM EST) 8% today (Monday, November 28th). Some would say a VIX in the sub or low 20s is underpriced relative to the true fragility/volatility of the markets, while others take the view that the economic situation is stable and bound for recovery. Considering the general theme of the year, a probable reversion would dictate another significant rise in the VIX (coinciding with a fall in the general US equities markets).
A general prevailing thesis suggests the Federal Reserve’s intentions will reflect a continued significant drop in the price of securities until sometime in 2023. Of course, the latest rally argues otherwise. Whether it was an irrational short-term run-up remains to be seen.
The nature of the current inflation calls into question the extent to which the Federal Reserves current actions are in reducing inflation. In an article by Kirian Van Hest (Desogames), he states, “Even if enough people are priced out of the market, not enough capital is”.
Furthermore, the newer method of monetary tightening, Quantitative easing, may not be as effective as some think, as the liquidity that entered the economy, and the location in the economy where money is causing inflation may not be removed as easily as it entered, another point Kirian Van Hest discusses in his article, “The Problem is Too Big”.
That said, both rate hikes and QT will have tangible effects on the economy and inflation. However, the degree to which it will effect the latter is somewhat unknown or imprecise as of now.
Even further, it is said raising interest rates to a “neutral level” where inflation is brought under control could be difficult without the (some would say paradoxical) reintroduction of quantitative easing to support the economy in the face of high rates. Of course, the introduction of QE could negate some of the disinflationary pressures intended prior.
Several months ago, this may have been outlandish. With the recent events surrounding the Bank of England, its less so.
Overall, a continued general trend down for US markets over the next 6-10 months or so appears reasonable, with a potential pivot changing the trajectory one way or another. Indeed, the variety of potential outcomes is likely not accounted for by the markets, and significant turmoil could still be in store for the financial and equity markets.
What a pivot would entail depends on the circumstances. Will it be a proactive decision, or a reactionary measure to a marked issue?
The high levels of debt are concerning for the stability of the economic markets. Since 2008, borrowing money has occurred at an alarming rate. For the United States, government debt has risen over 250% since 2007.
Debt-to-equity ratio has consistently stayed above 80% since the GFC of 2008. This indicates a theme of highly leveraged businesses, more zombie companies, etc.
With the low interest rates and quantitative easing of the past decade following a global financial crisis, many would say the general outlook must be negative in the face of rising rates and inflation.
A general theme of unsustainable Central Bank intervention (in its current form) has been present. For example, as of 2020, 80% of Japan’s ETFs were owned by its central bank.
It is the existence of periods like these that are why Warren Buffet says one should dollar cost average over long periods of time into a broad index fund (so one can own of a piece of America). How the situation will play out may still be unclear, but it could be safe to say the confluence of certain unprecedented factors warrant significantly reducing risk for the near term. What is and isn’t low risk may prove surprising over the coming months and years.