Investment Strategy

Market whiplash: Will the Fed get inflation under control?

May 06, 2022

The latest rate hike led to the worst selloff since 2020, but we believe Fed policy will help keep growth in balance.

Madison Faller,  Global Market Strategist

Chris Seter, Fixed Income Strategist

 

Our Top Market Takeaways for May 06, 2022.

Thoughts on the selloff

It was the best of times, it was the worst of times

 

Stocks soared high, and then they sank. This week saw both the S&P 500’s best day and (almost) its worst day since 2020.

The Federal Reserve’s latest policy meeting was at the center of the consternation.

On Wednesday, the Fed hiked its policy rate by 50 basis points (bps)—the largest increase since 2000—and laid out plans to start reducing its massive balance sheet. But those moves were widely expected heading into the meeting, and the real “new” news came when Chair Powell took the mic at the press conference and delivered a double-edged sword.

While Powell seemed to rule out a mega 75 bps hike, suggesting that the Fed might not be as aggressive as markets were chalking it up to be (fueling stocks higher on Wednesday), investors were quick to refocus on the fact that a handful of more hikes (“a couple” of them likely 50 bps) are still on the table to get inflation and labor tensions under control (stoking already elevated recession fears and catalyzing the selloff). Some analysts also lamented poor positioning and technicals, and it likewise didn’t help sentiment that the Bank of England followed with its own hike yesterday, accompanied by a growth outlook that all but called for a recession in the country.

This chart shows the market expectations for the number of 25 basis point hikes from the current level and implied fed funds rate throughout 2022. At each of the remaining FOMC meetings this year, the market expects: - June 2022: Number of 25 basis point hikes from current level (2.2) and Implied fed funds rate (1.4%) - July 2022: Number of 25 basis point hikes from current level (4.1) and Implied fed funds rate (1.9%) - September 2022: Number of 25 basis point hikes from current level (5.7) and Implied fed funds rate (2.3%) - November 2022: Number of 25 basis point hikes from current level (6.9) and Implied fed funds rate (2.6%) - December 2022: Number of 25 basis point hikes from current level (7.9) and Implied fed funds rate (2.8%)
Rates swung wildly in response. Bonds continued their worst selloff in decades, with 10-year Treasury yields popping almost 20 bps before settling at their highest level since 2018 (just below 3.10%). Likewise, 75% of S&P 500 stocks headed into Friday in correction territory (down 10% or more from their 52-week highs). Tech, in particular, bled lower, with the NASDAQ 100 cratering 5% on Thursday alone. Crude popped back above $110/barrel, and the dollar rallied against its major peers.
This chart shows the intraday data for the S&P 500 Index level and 10-year Treasury yield through May 4 and May 5, 2022. The S&P 500 opened at 4,180 on May 4, and the 10-year Treasury yield at 3.00%. All series were relatively flat in the morning of May 4 before the FOMC meeting at 2:00 p.m., when the S&P 500 was at 4,188, and the 10-year Treasury at 2.96%. Following the meeting, the S&P 500 rallied to a series high of 4,301,but closed the day at 4,239. The Treasury yield fell after the meeting. The 10-year dipped to 2.90% before picking up 3.01% at the end of May 4. On May 5, the S&P 500 fell sharply in the morning from 4,239at the open to 4,135at 11:45 a.m. From there, the index fluctuated around 4,150, where it ended the trading day. The 10-year Treasury yield was not as volatile as the S&P 500 Index, with the yield moving three basis points higher on May 5 to end the series at 3.04%.

If anything is clear from this week’s price action, it’s just how difficult of a job central bankers have before them. Hiking rates comes at a cost—mortgage rates are the highest they’ve been since 2009, and housing affordability is under pressure—yet is necessary to cool things down. But do too little, and inflation could spiral to the point of recession. Do too much, and borrowing costs could move too high and growth could become too scarce—and again, instigate recession. 

Critically, we still see a path for a bull case to come to fruition from here (predicated on still fundamentally sound growth, moderating inflation and confident corporates), but the Fed’s runway to get it right is narrow. 

Spotlight

The path forward

 

The Fed knows it’s in a jam. Powell himself acknowledged inflation is “much too high” and the labor market is “extremely tight.” It is clear the Fed is acting swiftly and aggressively now precisely because those pressures are a clear risk to growth.

That begs the question: How does the Fed land the plane? We are monitoring three dynamics:

1. How well higher interest rates do their job

Much of the Fed’s rate hiking cycle has already been baked into markets. As a result, rates have risen a lot—so much so that some sectors are already feeling the pinch. A recent Gallup survey showed that only 30% of Americans think now is a good time to buy a house—over 20% lower from just a year ago, and below 50% for the first time since at least 1980. Slower housing growth and eventually lower home values have clear knock-on effects when you consider that close to 65% of Americans own a home. Retail sales reports are already showing consumers are starting to spend selectively.

This chart shows the U.S. national average 30-year fixed mortgage rate from 2003 to 2022. It began at 4.9%, jumped to 6.1% by mid-August 2003, and repeated that trend until late June 2005 at 5.1%. It then rose to 6.4% in early July 2006. By late October 2008, at 6.4%, it began falling. It reached 4.3% in early November 2010 and 3.4% in late December 2012. It rose to 4.6% in mid-July 2013, then began falling to 3.3% by late September 2016. It rose to 4.8% by late November 2018, then fell to a series low of 2.9% by mid-February 2021. It then jumped to 5.41% by mid-March 2022.

Put simply, interest rates today are tightening financial conditions even though the Fed is just a few hikes in.

2. How inflation might decelerate

Rampant price pressures have been driven by a combination of super strong demand and lacking supply. As financial conditions tighten (see point above), we think goods demand should moderate. At the same time, supply has been improving. Companies have been adding back inventories across the board over the last two quarters, building back a decent cushion even as lockdowns in China disrupt supply chains. We are in a fundamentally better starting place than during peak of the pandemic, when consumers weren’t able to also spend on services.

This chart shows the inventories to sales ratio (total retail excluding motor vehicles and parts) from 2015 to March 2022. It began at 1.26, rose to 1.30 in January 2016, then steadily fell to 1.18 in March 2020. It spiked to 1.34 in April 2020, then dramatically fell to 1.08 by July 2020. It rallied slightly, then fell again to a series low of 1.03 in March 2021. By March 2022, it ticked slightly higher at 1.12.

To be sure, spiking energy prices also remain a risk, but it’s worth noting households broadly still have ample cash on hand from pandemic-era stimulus to help navigate costs.

While we may need to muddle through several more hot reports in the meantime, slower growth on the back of tighter financial conditions, continued normalization of COVID-19-driven inflation, and tougher year-over-year comparisons should, in our view, allow price pressures to begin decelerating into year-end.

3. How labor market strains can cool

The Fed isn’t just considering inflation in its pledge to remove policy support. The unemployment rate is nearing a five-decade low, employers are having a hard time filling job openings, and wages are rising swiftly. These dynamics are key to watch—so long as tightness persists  in the jobs market, it’ll be hard for the Fed to take its foot off the gas (even if inflation alone moderates).

But, there is already some evidence that wage growth may be starting to peak and, so far this year, workers have been coming back into the labor force. We think this trend can continue, particularly as households spend down their savings and the pandemic continues to wane (over 580,000 workers are still sitting on the sidelines due to COVID).

All that said: We believe that Fed policy is already having its intended effect in removing the pressure and slowing things down, giving the central bank some leeway to undertake less hikes than the market is currently pricing.

Investment takeaways

Focus on quality, both in stocks and bonds

 

As the cycle matures, we are focused on protecting gains while adding ballasts to portfolios that could protect against higher volatility. The selloff may present a compelling entry point to embrace both stocks and bonds—but importantly, quality is essential. There are several actions we think investors should consider.

Now looks like the time to add to core fixed income. As we said before, rates have already risen a lot, and the negative economic feedback loop from higher rates limits their room to move higher from here. Sure, rates could still float upward—but even if 10-year Treasury yields climb to the realm of 3.5%, our analysis (based on historical moves in credit spreads) suggests that core fixed income would be just roughly flat to down 1%. (Remember: As bond yields move higher, prices move lower.)

On the other hand, we think it is more likely that slowing growth and inflation bias rates move lower. Our outlook for 10-year Treasury yields to finish the year around 2.5% implies core fixed income could return more than 5% from here, and in the event of a downturn (which, again, is not our base case), returns could be as high as 15%. That all said, we think whatever an investor could lose from any move higher in rates seems worth the protection that duration could provide. 

This chart shows the potential returns for U.S. Aggregate Bonds and Municipal Bonds in different scenarios: - What if 10Y rises to 3.5%?: U.S. Aggregate Bonds (-1%) and U.S. Municipal Bonds (0%) - Base Case + 25 basis points: 2.75% 10Y: U.S. Aggregate Bonds (5%) and U.S. Municipal Bonds (5%) - Base Case: 2.50% 10Y: U.S. Aggregate Bonds (7%) and U.S. Municipal Bonds (6%) - Base Case -25 basis points: 2.25% 10Y: U.S. Aggregate Bonds (9%) and U.S. Municipal Bonds (7%) - Recession: 0.75% 10Y: U.S. Aggregate Bonds (15%) and U.S. Municipal Bonds (11%)

Get more defensive and monetize volatility in stocks. For the first time in years, we don’t think we’re paying a premium for equities. Equity valuations have compressed meaningfully and are back in line with longer-term averages. Given expectations of slowing growth ahead, we are particularly constructive on quality companies with strong balance sheets and high-quality earnings (healthcare, in particular, fits this bill). And with volatility as high as it is, some investors might also find it beneficial to use strategies that can take advantage of these swings as well as add protection.

Above all, stay invested. As this week has shown, the best days and the worst days tend to cluster together. Over the last 20 years, seven of the 10 best days occurred within just over two weeks of the 10 worst days. That said, it may feel tempting to hit “sell” after days like yesterday, but missing out on the potential best days that may follow and the opportunity to recoup losses can dramatically impact longer-term returns. Your J.P. Morgan team is here to help you navigate the uncertainty.

This chart shows the annualized performance of a $10,000 investment from April 2002 through April 2022. It shows the different return levels when fully invested, missing the 10 best days, missing the 20 best days and missing the 30 best days. In each of the scenarios, the return is: Fully invested: $10,000 returns $57,641, which equates to a 9.15% annual return. Missed 10 best days: $10,000 returns $26,407, which equates to a 4.98% annual return. Missed 20 best days: $10,000 returns $15,702, which equates to a 2.28% annual return. Missed 30 best days: $10,000 returns $10,189, which equates to a 0.09% annual return. Additionally, it’s always darkest before dawn. Seven of the 10 best days occurred within 15 days of the 10 worst days.

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