Did the Fed Crash the Party?

Jeff Bratzler |

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Stocks fell sharply following the release of the Fed minutes from the December FOMC meeting. It seems that the Santa Claus rally proved not to last as expected, with the Nasdaq composite giving back nearly all of its gains from Dec. 21. The S&P 500 has fared a little bit better, giving back half of its gains to this point. The FOMC minutes noted that the Fed plans to reduce the balance sheet size shortly after the first rate hike. That would be much sooner than many expected, adding another wrinkle to a changing macro backdrop in 2022. This hawkish tone from the Fed has sent a shockwave through the bond market, with yields moving sharply higher, especially on the front of the curve. Additionally, the Fed Fund Futures for December 2022 is now at 87.5 basis point, suggesting a full three rates hikes for the year. Meanwhile, the futures for March 2022 are currently trading at 19 basis points, reflecting the possibility of the first-rate hike. Rising rates, tighter monetary policy, and the balance sheet reduction will make it more challenging to maintain the high earnings multiples currently priced into the market. The S&P 500 is still trading at 20.3 times its next 18-months earnings estimates, higher than previous highs over the last 10 years. Now that earnings growth is forecast to rise by just 9.4% over the next 18 months, the valuation on the S&P 500 has gotten even more extreme. What makes everything more treacherous is when the Fed tightens monetary policy during clear signs of slowing in the economy. The Fed GDP model is forecasting fourth quarter growth of 6.7%, but that's down from a more than 9% reading at the beginning of December. On top of that, the latest ISM manufacturing and non-manufacturing data missed expectations by a lot and were down month-over-month, and trends suggest further slowing to come. The most recent polls from Reuters show that expectations are for GDP growth to slow to 4.0% in the first and second quarter of 2022 and then slow to 3.3% and 2.5%, respectively, in the third and fourth quarters. It seems clear that with the Fed on a mission to tame inflation and a more hawkish stance, those GDP estimates will come down further over time.