Market Update: End of Easy Money –Volatility Is Back
Financial environment remains positive for stocks
Corrections are normal and often healthy events
Speculative investments face increased risk
For much of 2021, the overwhelming majority of economists, strategists and market pundits were not expecting any Fed rate hikes until 2023. By the fall, though, with pandemic-driven supply/ demand imbalances keeping pressure on inflation longer than originally forecasted, expectations for higher Fed Funds in 2022 started to increase. Still, when minutes from the December FOMC meeting were released in early January, the surprisingly hawkish tone, aka the Powell Pivot, caught many investors by surprise.
As incoming inflation and wage data continued to run hotter than expected, market expectations quickly pivoted to four rate hikes in 2022, while concerns the Fed was falling behind the curve, along with lack of clarity on the balance sheet runoff, exacerbated market fears. Rates across the yield curve rose, which in turn triggered one of the steepest sell-offs in equities since the pandemic in general, and speculative technology stocks in particular. And, with 80% of the global asset classes we track, including bonds and alternatives, starting the year in the red, the sell-off has not been limited to equities.
So, what’s behind the sell-off? It has not been one thing, but rather the confluence of multiple events. The Powell Pivot, the end of easy money, rising U.S. and global interest rates, real yields increasing globally, geopolitical risks, profit taking after a great 2021, and continued concerns over inflation and wages all have come together to produce a healthy dose of fear that’s been amplified by panic selling, with anecdotal evidence that leveraged investors, algorithmic and short-term traders and hedge funds have been rushing for the exits. The “rotating correction” we’ve discussed for a few months, which started with EM Asia in the spring and was followed by U.S. Mid/Small cap stocks in the summer, spread in November to speculative tech stocks, which went from a corrective stage to a bloodbath quickly, before finally shifting to include quality and growth stocks in the NASDAQ and S&P 500, both of which ended 2021 near all-time highs and were ripe for a correction. No matter the exact cause, a real correction after the historic run since the market bottom is one we have long felt was overdue. Corrections are normal and often healthy events, helping to eliminate excesses that have built up after an extended period of optimism and setting a firmer foundation for future gains. As the chart below illustrates, stocks have experienced intra-year declines of 14% on average since 1980 with most years ending positive.
So, is it all the Fed’s fault? Yes and no. Were it not for the Fed, aggressive fiscal stimulus and best-case outcomes with COVID-19 vaccines, the multiyear economic growth outlook would not be as solid as we see it. Also, can we really blame the Fed for being off on the use of “transitory” in its messaging and being behind the curve on inflation? Not completely. The last pandemic was 100 years ago, and quantitative predictive models, as much as they have improved over the many years, can’t really factor in supply/ demand distributions brought about by government lockdowns and other pandemic distortions, unprecedented fiscal stimulus, and behavioral shifts that have impacted working from home, including the Great Resignation and increased retirements. Indeed, the rise in inflation is not a U.S.-centric issue but a global phenomenon. While the release of the Fed minutes in January has been blamed for the market sell-off, as we see it the Fed deserves some credit. The “messaging channel” has simultaneously deflated excessive valuations in speculative stocks, real interest rates have increased, the yield curve has widened from 70 bps to 90 bps and five-year forward inflation expectations have declined from 2.3% to 2%.
What are the implications of the end of easy money? Although much depends on the continued impacts from COVID-19, direct and indirect, we expect that the pace of Fed hikes, along with a gradual runoff of its balance sheet, will not be enough to change our long-term outlook for multiyear expansion. Economic fundamentals remain very strong, and Fed policy, while tightening, will still be far from restrictive. Nevertheless, there are areas that should be positively and negatively impacted. On the positive side, consumers and corporations will see increased interest paid in money market funds and related accounts, asset-sensitive financial stocks will benefit from higher rates as well as likely increased loan demand, and quality companies with pricing power and low debt levels should perform well. Areas that can be expected to be negatively impacted include speculative stocks, consumers with high exposures to speculative investments, investors and companies that have used high leverage in producing above-average gains, and companies that lose money from current operations and were relying on the never-ending flow of easy money to fund growth initiatives.
So, is it game over for stocks? Absolutely not. Growing concerns regarding the Russian troop buildup on the Ukrainian border, as well as heightened tensions with China, have led us to recently increase the risk level on our geopolitical speedometer. Still, absent any exogenous shocks that might come to pass, the fundamental outlook for stocks remains solid. We continue to believe economic activity on a global basis will begin to recover as Omicron recedes and winter ends, and we continue to expect above-trend growth in 2022 unfolding as the economy transitions from policy-induced recovery to more self-sustaining expansion. Nominal GDP growth (real GDP plus inflation) this year is likely to be around 8%, which is supportive of a positive outlook for healthy corporate revenue increases and EPS growth of 7-17%. Meanwhile, delinquencies and defaults for consumers and corporations remain low. Supporting this optimistic view has been the resiliency of BBB yields, which have moved up only modestly while equity markets have been pummeled. Stocks can sometimes initially struggle to adjust to changing policy conditions, but returns have historically been positive over the first two years of Fed tightening cycles (see chart below). More important than the direction of policy is the state of the economy. When the Fed is removing stimulus because the economy is on solid footing, and recession risk is low, stocks tend to do very well.
What’s the bottom line? While ever watchful for exogenous shocks, we’re staying the course on our multiyear expansion thesis and overweight to risk assets, and view this correction as long overdue and a buying opportunity.