The Fed Won't Save Us This Time

Eric Parnell, CFA |

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Since the Great Financial Crisis of 2008, we have had five previous major episodes where the S&P 500 dropped by -15% or more. Each of these past price drops were accompanied by definite disinflationary/deflationary signals including sharply declining bond yields and/or commodities prices. This afforded global monetary policy makers complete and total flexibility to react almost immediately if not reflexively with a massive and dramatically supportive response. Each time this sent U.S. stocks almost instantaneously sharply rebounding back to the upside. Unfortunately for investors, that’s not at all what we have converging across financial markets today. Since the second trading day of 2022, U.S. stocks have been moving steadily to the downside. This includes a -15% peak-to-trough decline in the S&P 500 and an even more pronounced -22% drop in the tech heavy NASDAQ Composite Index dating back to just before Thanksgiving. But in total contrast to the five past episodes highlighted above, these declines have come with the backdrop, if not the result of, rapidly escalating inflationary pressures. This has included 10-Year Treasury yields rising back above 2% and oil prices spiking above $100 a barrel. During each of the past five episodes, the Federal Reserve would have been scurrying to the market rescue with major monetary support to save the day. But the absolute exact opposite is happening today. Instead, the Federal Reserve not only closed up shop with its final COVID related QE asset purchases on March 9, but it moved a few days later to raise interest rates by a quarter point for the first time since late 2018. And when announcing this first rate hike, the Fed suggested to the market that it should expect at least six more quarter point hikes through the remainder of the year. Making matters worse, signs are also starting to accumulate suggesting that an economic recession is becoming an ever greater probability as soon as toward the end of this year. Looming stagflation anyone? But unlike the last five times since GFC, the monetary policy support and liquidity that helped spark the major stock market rebounds to the upside is not only gone, but the Fed is only now just getting started with taking an increasing amount of liquidity away. Despite what stocks may have done last week in the immediate aftermath of the Fed announcement, they are very unlikely to like this shift in the liquidity tides very much at all as we continue forward into the spring and summer. This is particularly true with stocks already trading at a frothy 25 times earnings. And if it turns out that either inflation remains persistently high and/or Treasury yields continue to rise and/or the economy slows into recession, then investors should brace for an even more pronounced downside move in stocks as we continue forward. They aren’t reversing course on anything until they definitively get inflationary pressures under control. This means that the Fed is likely to be heavily biased toward tightening monetary policy aggressively at least for the next few months if not longer, as the 1970s and early 1980s taught the Fed that an outbreak of high inflation must be completely snuffed out before attention can turn back to supporting economic growth and/or asset prices. Sure, the Fed might eventually come to the rescue, but what damage will stocks have sustained by the time they are ready and able to do so? At 25 times earnings with sharply rising input costs and potentially slowing economic growth, the potential downside damage could end up being profound before it is all said and done. Thus, it will be critically important to monitor market developments closely in the weeks and months ahead.