By Jacob Manoukian, JPMorgan
This week, the Federal Reserve raised policy rates by 75 basis points (bps), which it hasn’t done since 1994.
The Fed’s message seems clear: It is solely focused on containing inflation, and it is willing to harm growth to do it. Many investors are now assuming that a recession is necessary to cure the inflation problem. It shouldn’t be surprising, then, that global assets have sold off aggressively since last Friday.
U.S. stocks are down almost 8% since U.S. headline consumer price data was released last Friday, which has wiped out all the gains made since the end of 2020. Bond yields across the curve have soared.
U.S. 10-year yields started the week at 3% and reached 3.5% for the first time since 2011 before coming back down to ~3.2%. The market now expects the federal funds rate to peak at almost 4% by the spring of next year.
What to make of it all? Our experts hosted a webcast yesterday in which they discussed the Fed meeting along with several other dynamics driving global markets, and offered several steps to help maintain discipline through discomfort.
In the rest of today’s note, we offer five observations that illustrate what has been a critical week for markets.
1. The Fed is willing to harm growth to control inflation
It expects policy rates to be more restrictive, and it expects below-trend growth. On the labor market, the Fed’s 2024 projection for the unemployment rate is 4.1% versus 3.6% today, which, assuming a constant labor force, implies about 800,000 fewer people on payrolls.
This projection is buzzing the tower of recession. Importantly, economic data and corporate anecdotes from this week suggested an environment of already weakening activity. Retail sales for the control group came in effectively flat in the month of May, while housing starts collapsed by over 14%.
Pending home sales in California dropped over 30% in May. Companies such as Tesla, Coinbase, Redfin, Compass Real Estate, Warner Brothers and Spotify have already announced layoffs or hiring freezes this week.
2. Prices at the pump matter
Markets were expecting a 50 bps move until a suspiciously well-sourced Wall Street Journal article published on Monday strongly hinted that it would be 75 bps. Why the switch? Fed Chair Powell suggested that the most recent CPI data, and perhaps more importantly, the University of Michigan inflation expectations survey from last Friday, forced the Fed into a more aggressive action.
The problem is that both data points were heavily influenced by higher oil prices. Gasoline accounted for 20% of the monthly change in the CPI Index, and the UMich survey has an uncanny correlation with prices at the pump. Lower oil prices may be the quickest way to fewer rate hikes, while further gains could mean a more aggressive Fed.
3. Tightening is a global phenomenon
Just this week, central banks in the United Kingdom, Switzerland, Taiwan, Brazil and Hungary raised interest rates. The European Central Bank seems set to raise rates later this summer, but its plans are being complicated by emerging stress in peripheral member states (namely Italy).
There are even growing questions about the sustainability of the Bank of Japan’s yield curve control program. During the last cycle, investors could count on global central banks to pin policy rates at ultra-low levels, which reduced volatility across asset classes. Now that central banks are being forced to respond to inflation, volatility seems set to remain elevated at levels more akin to the early 2000s than the mid-2010s
4. Stock markets are under pressure
The S&P 500 officially entered bear market territory this week and currently trades about 25% below its all-time high. Only seven stocks in the S&P 500 are within 10% of their 52-week highs, and only 12 of the 47 countries we track have positive performance this year.
Within the S&P 500, several sectors are approaching drawdowns that could be described as recessionary. The consumer discretionary sector’s 33% drawdown has erased all gains made during the pandemic era, and is commensurate with that seen during the last four recessions.
We probably aren’t there yet, but the equity market is getting closer to reflecting a slowdown in economic growth that would be deeper than we think is likely, given solid corporate and financial sector balance sheets and a resilient, if strained, consumer.
5. Discipline through discomfort
Bear markets can be painful, but enduring them is critical for long-term investment success. The only periods when the market was down 10% or more one year after stocks had already entered a bear market were from November 1973 to April 1974, June 2001 to June 2002, and July 2008 to September 2008. Similarly, historical forward returns over 3-, 6-, 12- and 24-month periods have been higher if the starting point was during a bear market rather than on any random day. The only good thing about bear markets is that they tend to turn into bull markets (eventually).
Before we get too despondent, there is still a decent case for a more positive path forward. Discounting could make a major comeback this summer, given elevated retailer inventories, and shipping rates are about to decline on a year-over-year basis.
That should help lower goods inflation even further. Wage growth is already slowing, reducing the risk of a wage-price spiral.
The pandemic-era imbalances in the digital economy are unwinding rapidly, all while incomes maintain spending on services. Equity markets are historically oversold and will likely be higher in a year than they are today, even if we haven’t reached the bottom yet.
In our Mid-Year Outlook, we made three suggestions on how investors can navigate this uncomfortable environment.
First, core fixed income yields are implying compelling returns on a go-forward basis, and would likely provide protection if a recession does come to pass. Next, quality equities should outperform as the Fed continues to campaign against inflation.
Finally, we think there are compelling opportunities to position for structural change through this cycle and next.
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