Double Market Shock: What Next For US Equities?
Monday this past week was one of the craziest days in financial markets we have ever witnessed. That isn't just our opinion. On that date, $105 billion of volume of shares was traded in the S&P 500. That is a lot.
In the stock options space (wagering on the future, not present, price of an asset) it was apparently the single largest day ever with well over 63M option contracts traded.
The previous record? Last Friday, the 21st of January.
These record numbers suggest that investors are making a lot of bets about the future direction of the market and companies' share prices all at once. This is causing dramatic moves as manager's urgency and willingness to pay up to change their portfolio creates wild swings.
For instance, at one point on Monday the tech-heavy NASDAQ index was down nearly 5% and then proceeded to stage an incredible rally, finishing the day in positive territory!
Though Monday was the standout, the rest of the week was pretty similar in tone if not in tenor. As we have stated a few times since the turn of the new year: this isn't normal.
All of this, of course, was BEFORE the critical Fed meeting on Tuesday-Wednesday of this past week.
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So, what is going on?
Two great issues are griping investors and causing serious market volatility:
A "rate shock."
Rising fears of a related growth shock.
The rate shock is easy and we have covered it in depth though it is now accelerating.
Rate expectations were too low in the second half of 2021. Somehow this remained the case late into the autumn as the debate about inflation continued and the Fed kept to its stubborn "it's really just transitory" thesis.
Then in late November Chair Jay Powell declared the word transitory to be "retired" in testimony to lawmakers and the Federal Reserve pivoted to accepting they would have change their policy to counteract high inflation.
The shift in expectations around interest rates gathered pace at the December FOMC meeting and then really took off at the release of the minutes for that meeting in early January.
The change has been extremely rapid. For context:
There were zero 2022 interest rate hikes expected at the start of October and
Now there are 4-5 (see below) and rising.
Some analysts and banks are even calling for 50 basis point hikes (as opposed to the more normal 25 points or 0.25%) as early as March.
This would be a pretty radical move!
For now, here is the number "priced in" at the time of writing. It is is above 4.5+ hikes for 2022:
The Federal Reserve was caught out by the higher inflation piece and, as the chart makes clear from October on, the central bank is now pivoting hard and the market's reaction is proving sloppy and chaotic.
This sudden monetary policy reversal is a big shift and represents the onset of a regime change: which is causing a sharp and in some ways vicious reassessment of what you want to own.
The reason?
We are moving from a world of exceptionally cheap money to one where the cost of capital (i.e.: money) is rising. By how much, investors are not sure.
Therefore, higher interest rates impacts nearly everything else: the cost of borrowing are rising for businesses and consumers as well as the costs of living for average households. As we have covered at length, growth assets and especially unprofitable growth companies have been severely punished.
Value companies continue to be the near mirror image of growth.
Here is 2022 year to date so far:
Lastly, higher interest rates are not just more expensive for companies or consumers. They are also change the calculus for the state itself.
Whisper it quietly but, as interest rates rise, so does the cost of servicing the massive new pandemic borrowing for the government.
We would be amazed if the last theme doesn't resurface at some point soon in market commentary.
For now, however, let us keep the focus on the second shock.
Fears of a growth shock, however, is relatively new and it is directly related to this Fed pivot.
It stems from something we have mentioned in passing but want to make the focus here:
Suddenly after months of pretending it was unlikely to happen, investors have come to realize the Fed no longer has their backs and will not necessarily come to their rescue during a strong selloff.
This has been a rude awakening. Implicit in a lot of investor behavior for years has been that the Federal Reserve would support the market if things looked dire.
This is commonly known as a "moral hazard" in a lot of circles. A moral hazard is a perverse incentive to engage in excessive risky behavior because you believe you will not suffer the consequences of your (risky) actions.
It is a concept that has been around for a long time and was made famous during the Great Financial Crisis in 2008. It certainly didn't disappear in that time however.
In fact, the central bank's behavior has arguably only further entrenched this problem since. Hence the constant focus on "Buy the Dip" behavior.
Now, however, as we have tried to stress for the better part of the last 6 months, higher inflation changes the Fed reaction function and removes its ability to support financial markets.
In fact, it may ensure the exact opposite.
Why?
Well, because they must hike interest rates to combat the elevated inflation. Keeping inflation moderate is a full half of the US central bank's dual mandate and there is very little wiggle room when inflation is at 7% and their target is 2%.
So, no matter how bad the markets sell off or, more critically, if growth starts to slow, the Fed will struggle to continue easy monetary policies when their mandate is very clear: they must keep inflation moderate.
Therefore the takeaway has been that: growth has to stay robust or else.
This removal of support has been a sudden and very unpleasant realization for a lot of investors. It had likely been dawning on some portfolio managers and analysts for awhile but really hit home with the January 5th release of the FOMC's minutes from their meeting in December.
Hence the spike in volatility thereafter.
Further, during a vital election year the political pressure - for the first time in a long, long time - will not be weighted towards protecting investors' risky investments but rather geared towards defeating the inflation bugbear that is dominating headlines.
With interest rates effectively at 0%, the unemployment rate at 3.9% and inflation far above the intended threshold what other choice does Jay Powell or the Fed have?
It is a toxic brew - both for US politicians facing reelection in November and US consumers and investors who are facing the potential of higher prices+less growth and declining financial markets.
The challenge?
The problem for investors is that you can be understand and be prepared for a rising cost of money. Jay Powell and the Federal Reserve have telegraphed that very clearly, at least recently.
But it is far harder to feel confident about the direction of growth. Especially with so many big unknowns and rapidly shifting critical metrics that will impact growth.
As we noted last week, as financial conditions tighten higher and higher the probability of that occurring and especially of a Fed "mistake" is also rising. A Fed mistake would be when they commit a monetary policy error by raising interest rates when growth is already meaningfully slowing down and it tips
Here are financial conditions. Rising but by no means that elevated yet:
So it is a finely balanced. Growth isn't slowing down for sure yet but many investors are starting to hedge their portfolios to reflect the fact that it could.
And if the growth does slow down, there is no central bank safety net.
Add in a host of pandemic uncertainties thrown in and it is hard to know how what to expect in 2022.
Put it all together and it is perhaps not surprising that investors are jumpy. You may have likely noticed!
Lastly, it also raises big question of whether - having waited too long to meaningfully tighten policy - the Fed now risks being unable to thread the needle between maintaining growth while curtailing inflation.
The big fear is always that a Fed mistake could be so violent it tips the US into recession.
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