Economy & Markets

Will the Fed be the market’s friend or foe in 2022?

Feb 16, 2022

The economy and risk assets could power through higher interest rates this year. Here’s why.

The Federal Reserve has been the market’s strong, steadfast ally since the start of the coronavirus crisis in early 2020. But now inflation is forcing a big shift in policy, and stock markets are feeling the strain.

While the Fed has spurred one of the worst January for stocks on record, we think the economy and risk assets could power through higher policy interest rates through 2022. Here’s why.

Lessons from past Fed policy rate hiking cycles

There is a long history of economic slowdowns coinciding with bear markets. We took a close look at the last 30 years to identify instances when the Fed effectively turned from friend to foe of the economy and markets. Out of the six economic downturns, only two were driven primarily by higher policy rates.

The first time was in 1994, when the Fed raised rates 1 by 200 basis points (bps). Even though corporate earnings grew by 30% that year, equity markets ended flat.

The second, and most recent, episode came in 2018. Rates rose by 85 bps, with Fed Chair Jerome Powell suggesting that a lot more tightening was on the way, even though markets were already starting to wobble. In the wake of that policy shift, and an emerging U.S.-China trade war, the S&P 500 sold off by 20%, a technical bear market.

GROWTH SLOWDOWNS SINCE THE 1990s

Sources: IHS Markit, J.P. Morgan Private Bank. Data as of 2019. *HP Filtered.
This chart shows the year-over-year growth of real and filtered trend GDP from 1993 to 2019. In 1993, real GDP began at 3.8% in February 1993, fell to 2.2% in September, rallied to 4.6% in September of the following year. This marks the first growth slowdown. Real GDP fell to 2.1% on February 1996 and rose to 5.1% by January 2000. This marks the second growth slowdown. It plummeted to -0.4% by December 2001 and rallied to 4.8% in June 2004. This marks the third slowdown. It fell to 1.8% by August 2008 and to a series low of -4.5% in July 2009. It rose to 3.2%, marking the fourth slowdown, before dipping to 0.7% by October 2011. It fluctuated a bit before rising to 3.8% in March 2015, marking the fifth slowdown. It dipped to 1.2% in March 2016 before rising to 3.2% in June 2018, marking the sixth slowdown. It dipped, then rose to 2.7% by December 2019.

KEY CHARACTERISTICS OF GROWTH SLOWDOWNS SINCE 1990

Sources: Bloomberg Finance L.P., J.P. Morgan Private Bank, Prof. Jing Cynthia Wu of Chicago Booth. *Note: The Shadow Policy Rate is a measure of the Fed Funds policy rate that takes into account the impact of quantitative easing.
This table shows the yield change on several indicators during the last six economic downturns: October 1994, September 1999, August 2004, January 2011, February 2015 and June 2018. The 10-year UST (yoy bps change) was +240 bps in October 1994, +110 bps in September 1999, -15 bps in August 2004, -35 bps in January 2011, -70 bps in February 2015 and +70 bps in June 2018. The USD (yoy % change) was +10% in October 1994, -2.1% in September 1999, -4.2% in August 2004, -2.5% in January 2011, +11.1% in February 2015 and 0% in June 2018. The Shadow Policy Rate (yoy bps change) was +200 bps in October 1994, +35 bps in September 1999, +90 bps in August 2004, -55 bps in January 2011, +50 bps in February 2015 and +85 bps in June 2018. The Shadow Policy Rate (deviation from neutral, bps above/below) was +40 bps in October 1994, 0 bps in September 1999, -280 bps in August 2004, -165 bps in January 2011, -430 bps in February 2015 and -75 bps in June 2018. And the Subsequent Equity Market Drawdown was -8.5% in October 1994, -50% in September 1999, -55% in August 2004, -19% in January 2011, -14% in February 2015 and -20% in June 2018. Finally, the table also shows the primary cause of the slowdown for each period: Fed Policy Tightening in October 1994, Stock Market Bust in September 1999, Housing Bust in August 2004, International/Euro Sovereign Crisis in January 2011, International/Commodities Shock in February 2015 and Fed Policy Tightening in June 2018.

A different growth and inflation backdrop

So far this year, equity markets have been rattled by expectations for a much more aggressive Fed than investors were expecting just a few months ago. Two-year U.S. Treasury yields have surged above 1.50%, while the S&P 500 lost 5% in January. The Fed is clearly not the market’s friend at the moment.

But we think there is a good chance that the Fed avoids the policy mistakes it made in 1994 and 2018—raising rates too high, too fast. A look at today’s growth, inflation and rates backdrop offers important context.

1. Growth. In 1994 and 2018, economic growth was accelerating through the rate hiking cycle. The Fed aimed to offset the stronger growth impulse in an effort to neutralize potential inflation. The economic backdrop is very different today. As fiscal and monetary stimulus fades and goods demand cools, the pace of economic growth will likely slow throughout the year (from historically strong levels in 2021). This likely lowers the chance of the Fed overtightening. 

2. Inflation. Not surprisingly, with consumer prices up 7.5% in January, the highest reading since 1982, policymakers seem intent on taming inflation. The good news: Inflation can decline in many ways that have nothing to do with rate hikes. Remember, inflation measures changes in prices, not absolute levels. Base effects (2022 prices will be compared to 2021 prices) will do a lot to bring inflation down. We expect that industry-specific issues in sectors such as used cars should start to resolve, and shortages of critical inputs should ease. We may already be past the peak of rent acceleration. By the end of the year, inflation could be much closer to the Fed’s 2% target than it is now. 

PRIVATE HOUSING MEASURES ARE POINTING TO COOLING RENTAL INFLATION

Sources: Zillow, 2022 Apartment List National Rent Report. Data as of January 1, 2022.
This chart shows the month-over-month percent change of rental prices in Apartment List and Zillow from 2017 to the end of 2021–early 2022. On Apartment List in March 2017, rental prices began at 0.08%, rising to 0.46% in May 2017. They dipped to -0.29% by August of that year before rising to 0.63% in March 2018. They dipped to 0.10% by June 2018 before remaining relatively range bound between 0.10% and 0% until March 2020, when they fell to a series low of -1.1% by May 2020. They rose steadily to a series high of 2.27% by July 2021. They fell at this point to 0.36% by December 2021. Most recently, they picked up to 0.41% by January 2022.

3. Rates. The 2018 rate hike episode proved especially disruptive because of a communication error. After the Fed raised policy rates to 2.25%, Chair Powell signaled that rates were “a long way from neutral.” The intended message, “We [the Fed] can and will raise rates a lot further,” was eclipsed. And the timing was tough. The economy, especially in the case of rate-sensitive sectors such as housing and autos, was already under pressure. Making matters worse, a U.S.-China trade war threatened to depress global economic activity as well.

What do we see today? February 2022 is not 1994 or 2018. We believe there is ample room for the Fed to raise rates before it causes a perceptible economic slowdown. While long-term interest rates have risen materially this year, they are still deeply negative after adjusting for expected inflation. A supply-demand imbalance and strong wage growth should continue to support the housing market. Even if the Fed raises rates by 150 bps or more this year, as the market expects, cash rates will still be well below inflation, which should incentivize investment and spending.

However, a more aggressive Fed does mean a greater headwind for equity market returns than we were expecting just a few months ago. This makes specific sector and stock selection all the more important. 

The risk: The economy is either too hot or too cold

We see two key risks to our view. The first is that the U.S. economy cannot handle even a modest amount of rate increases, and the rate hikes the Fed has planned this year could end up causing a recession. While we think growth will slow from last year’s pace, nearly a 40-year high, we still expect it to be relatively healthy. So far in 2022, the auto and housing market are pushing through higher long-term rates.

The second risk to our view is that the labor market is in fact overheating. In this scenario, a wage-price spiral is already underway, with markets underestimating how much policy tightening will be needed to bring wages and prices under control. While the job market does seem tight at a high level, we note that wage growth in sectors most impacted by the pandemic is running substantially higher than wage growth in sectors less affected by the pandemic. This suggests that the economy is not broadly overheating at a 3.9% unemployment rate. Recall that in the last cycle, the unemployment rate fell to 3.5% without causing an inflation problem.  

How should you position your portfolio for this environment?

We think earnings growth can drive equity markets higher through the end of the year, despite a more aggressive posture from the Fed. Within portfolios, we think two approaches can help investors broadly.

  • Focus on quality across equity sectors. Hardest hit by a more aggressive Fed are last year’s high flyers, money-losing companies that promised investors rapid growth and huge profits in the future. A basket of unprofitable tech and tech-adjacent companies is down over 20% so far in 2022, much worse than the market as a whole. Focusing on profitability should be increasingly valuable as interest rates continue to rise. And remember, there is more to the market than just technology. Owning companies that are linked to the real economy (in areas such as finance, industrials and pockets of the energy sector) probably makes sense in a solid growth environment, while healthcare should offer stable earnings growth. 
  • Check in on fixed income portfolios. It usually doesn’t make sense to invest too heavily in fixed income in a high inflation, rising rate environment. However, it might be time to revisit the asset class. Now that the market expects at least six rate hikes this year (as of Labor Day 2021 it expected no hikes this year), short-term yields look more attractive. Especially in this environment, active managers can pull various levers to potentially help outperform cash. It also probably makes sense to think about methodically closing underweights to core bonds as 10-year U.S. Treasury yields start to move toward 2%. 

The Fed will be more aggressive in 2022—there’s no getting around it. Markets will likely be more volatile. But as we assess the current environment, we think inflation can retreat to more tolerable levels before the Fed causes an economic downturn. And we still believe goal-aligned portfolios can deliver solid returns to investors this year.

Your J.P. Morgan team can help you build portfolios to navigate through the current market cycle.

 

 

1For this piece, we use the “shadow” policy rate (which accounts for balance sheet activity such as quantitative easing).

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