What Did Last Week's Moves Tell Us?
In a year that has featured plenty of volatility, last week's daily stock-market swings, which included both the largest daily gain and daily decline of the year, may have felt like something new was afoot. We would hardly file this under "much ado about nothing," but we don't think this should be interpreted as a sign that a new threat or narrative to the market has surfaced. Instead, we think this volatility is an ongoing symptom of this phase in which markets are struggling to handicap the outcome of this faceoff between Fed tightening and a still-viable expansion.
Coming into May, here's what we knew:
- Inflation is running too hot for comfort.
- The Fed is in the early stages of a tightening campaign aimed at curbing those inflation pressures.
- The underpinnings of the economy are reasonably sound, supported by a historically tight labor market and healthy consumer finances.
- Corporate America is holding up fairly well, with profits expected to rise at a decent clip this year.
- Stocks are under pressure amid an increasing fear that the Fed is going to topple the economy into recession.
- Bonds are enduring similar pressure amid sharply higher interest rates.
Given what transpired last week, here's what we know:
- Inflation is still running hot, but the latest trends indicate inflation is peaking and headed gradually lower.
- The Fed has executed the first of several outsized (0.50%) rate hikes, but it's not looking to pursue larger (0.75%) hikes or an even more aggressive pace of tightening.
- Ongoing supply disruptions stemming from the lockdowns in China, along with elevated consumer prices exacerbated by high oil prices, pose headwinds for the economy, but employment conditions continue to paint a positive picture for consumers.
- Corporate earnings are not immune to the rising-cost environment, but resilient profits remain a pillar of support.
- The correction in the stock market continues to run its course, with tech under pressure as valuations get repriced for higher rates.
Put plainly, while extreme swings in the markets may seemingly imply increased uncertainty, events and data last week simply confirmed what we already knew -- the Fed is going to keep tightening and the economy is still in decent (but not perfect) shape. Here are four key things that last week told us about the path ahead:
1. The Fed will keep its foot firmly on the brake to avoid steering into the ditch.
- The Fed raised rates by 50 basis points (0.50%) last week, the first hike larger than 0.25% in 22 years1. We think the largest takeaway from the meeting was that the Fed is committed to following through on aggressive policy tightening in the coming months to catch up with the inflation curve. We think it's likely that the next two meetings will also feature 50-basis-point rate hikes, along with an active approach to reduce the size of the Fed's balance sheet.
- At the same time, Fed Chair Powell signaled that monetary policymakers are not yet inclined to accelerate the aggressiveness with even larger rate hikes. We believe the Fed acknowledges the need to forge ahead with tightening despite the potentially punitive effects on the economy. However, to us, this suggests that the Fed still sees a window of tightening that is sufficient to bring down inflation without deliberately and completely snuffing out the expansion.
- In 1980, the Fed deliberately forced the economy back into recession in an effort to stamp out persistently and excessively high inflation. It did so by taking the federal funds rate from 10% to 22%1. By comparison, 1994 featured an aggressive tightening phase in which the Fed took its policy rate from 3% to 6% in the span of roughly a year, without producing a downturn in the economy1. The market is currently pricing in about a 2.5% increase in the fed funds rate this year1.
- We think the Fed will have to remain committed to steady rate hikes in coming months to establish credibility in fighting inflation. Not doing so would risk inflation expectations becoming unhinged. We think this will, to a degree, come at the expense of economic vibrancy and financial-market enthusiasm, but we still see a reasonable case for a "soft landing" scenario. There are notable differences today, but 1994 and 2018 are credible examples of such a scenario. We think last week's Fed announcement supports our view that the central bank will take an aggressive approach up front in order to create space for more flexibility later in the year as the impacts of initial tightening are assessed.
2. The market is pricing in a recession. We think risks are rising, but a recession is hardly guaranteed.
- The economy is slowing due to a combination of factors, including the fading boost from last year's stimulus checks, rising consumer prices that are dampening real wages and consumption, and ongoing supply bottlenecks. The recent pullback, along with last week's reaction to the Fed meeting, appears to be pricing in a consensus view that a recession is imminent. We don't dismiss these risks. In fact, our economic-cycle model confirms some late-cycle characteristics. One area of note is housing, which we think will be particularly impacted by the Fed's actions. We've already seen mortgage applications drop as rates have jumped, and we expect the pace of housing-price gains to simmer from the recent boil (which, by the way, would have the silver lining of reduced inflation pressures stemming from rising shelter costs).
- All that said, there is still plenty of evidence that the expansion has the ability to advance amid the sturdy headwinds from the Fed. In particular, the most powerful driver of economic activity, the labor market, remains a source of optimism. Last week's jobs report showed a 428,000 increase in payrolls in April, on par with the gains of the previous month and extending the streak of monthly job growth above 400,000 to 12 consecutive months. The unemployment rate held steady at 3.6%, just a tick above the half-century low.
- We recognize that the effects of Fed tightening have yet to seep their way fully through the economy, but we don't think the implications of a healthy labor market should be overlooked, which seems to be the case at the moment. Looking back at the recessions that began in 1980, 1990, 2001 and 2007, the unemployment rate bottomed, on average, 13 months before a recession. Moreover, the unemployment rate rose by at least 0.5% (and an average of 0.6%) before each of those recessions began. We think current unemployment has room to move lower from here, but we think an uptick in the jobless rate would be a requisite for an upcoming recession. While this is not improbable, we think tightness in the labor market can endure this year, helping offset softness in other areas of the economy.
This chart shows that the unemployment rate has fallen sharply and remains low compared to historical standards.
3. The bulk, but not all, of the rising-rate path has been traveled.
- One of the unique aspects of this market pullback has been the simultaneous declines in both stocks and bonds. This has sparked concerns among bond investors that the year-to-date declines are just the beginning. We don't share this view. There's no denying it has been an abnormal and painful period of fixed-income returns, but the yield curve is now pricing in significant rate hikes from the Fed this year. To the extent the Fed does not have to significantly up its rate-hike plans beyond current expectations (which will require inflation to start to moderate soon), we don't think interest rates have to take another dramatic leg higher from here.
- Yields have historically peaked slightly before the conclusion of the Fed rate-hike cycle1. Given the evolution of increased transparency and communication around Fed policy relative to past cycles, we think rates could reach a peak in advance of prior experiences. Thus, we think we're closer to the peak than the bottom. Longer-term rates may have more room to go given the upward influence of the upcoming balance-sheet runoff from the Fed, but our analysis suggests something around 3.5% could represent a peak for 10-year Treasury yields. Nevertheless, while we anticipate more moderate moves in yields as we advance, we don't see interest rates pulling back meaningfully until the end of the Fed's rate hikes are within sight.
- It's unlikely the Fed is going to reverse course in the near term, meaning that we doubt bonds will see an immediate snap back. This does not, however, mean bonds should be avoided right now. Here are three reasons why:
- While we think longer-term rates have the potential to move moderately higher, we think the majority of the move has already occurred. Thus, most of the pain in bond returns has, in our view, already transpired. In the absence of another surge higher for interest rates and barring a credit event or default, bond-coupon payments would still be made, and bond prices will naturally gravitate upward toward par as maturity approaches. In other words, short-term bond declines don't have to be repeated or permanent.
- While fixed-income returns have moved in the same lower direction as stocks recently, bonds still possess a low correlation to equities, supporting their diversification benefits in portfolios. During recent sell-off episodes in equities, bonds have rallied, indicating they still offer some potential downside protection for portfolios despite the backdrop of Fed rate hikes.
- Yields are more attractive than they've been in quite some time, presenting some potential opportunities within fixed-income positions to pick up some yield in short-term Treasury and municipal bonds, alongside CDs and investment-grade corporate bonds.
Source: FactSet. Past performance does not guarantee of future results
This chart shows that the bulk of increases to the 10-year treasury yield take place before the fed hiking cycle.
4. The stock market isn't as spry as it used to be, but now is not the time to throw in the towel.
- A glance at daily market moves last week may give the impression that volatility has moved to new territory. The Dow posted a 900-point gain on Wednesday, followed by a 1000-point drop the next day1. The S&P 500 has logged its three largest daily moves of the year within the last six trading days, and the Nasdaq experienced its worst daily drop since June 20201. This may feel ominous and extraordinary, but big daily swings are not simply a reflection of impending bear markets. There have been two days so far this year in which the S&P 500 declined 3% or more1. There were five such days in 2018, two in 2015, six in 2011 and five in 20101. For comparison, the bear-market years of 2008, 2009 and 2020 saw an average of 17 days with 3% declines1.
- The stock market has been down as much as 14% from its January peak, matching the average peak-to-bottom decline for past nonrecessionary corrections1. In the last 60 years, there have been two official bear markets (20%-plus declines) that were not accompanied by a recession (1966 and 1987), which featured an average drop of 28%1. While we can't rule out further weakness in equities as this inflationary and Fed policy phase plays out, history may provide some comfort that absent a full-on economic downturn, the current pullback may already have captured much of the downside.
- The correction in the stock market has almost exclusively come from a decline in valuations, as equites have been abruptly repriced for a higher-interest-rate environment. The forward price-to-earnings (P/E) ratio has dropped by 21% in 20221. Prior Fed tightening cycles were accompanied by an average P/E drawdown of 20%. This tells us that equities are already reflecting Fed headwinds and a reasonably high probability of recession, which offers some comfort that a fair amount of pessimism and potentially adverse outcomes are already priced in.
- The current environment bears many similarities to the Fed tightening phases of 1994 and 2018, during which markets grew increasingly convinced that monetary policy had gotten too restrictive. Stocks dropped 8.9% in 1994 and 19.8% in late 2018, before logging respective rebounds of 5.2% and 25.3% over the following six months1. Both of those recoveries were sparked by the Fed taking a pause on its rate-hiking campaigns. This aligns with our current view that we think a shift in Fed expectations will be a necessary catalyst for a more enduring shift in the market's current mood. We don't think equities have to post further or persistent declines in the interim. But we think a moderation in inflation pressures will be a trigger for sufficient confidence that the necessary amount of upcoming Fed tightening is already captured in the market. That, to us, would present the catalyst this year that will support further compelling gains in equities.
Source: FactSet, the S&P 500 is unmanaged and cannot be invested in directly. Past performance does not guarantee of future results.
This chart shows that rate hiking cycles have caused drawdowns in the S&P 500 in the past.
Craig Fehr, CFA
Weekly market stats
|Dow Jones Industrial Average||32,899||-0.2%||-9.5%|
|S&P 500 Index||4,123||-0.2%||-13.5%|
|MSCI EAFE *||1,972.82||-3.0%||-15.5%|
|10-yr Treasury Yield||3.13%||0.2%||1.6%|
Source: Factset. 05/06/2022. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Source: Morningstar, 05/09/2022.
The week ahead
Important economic data being released this week include inflation and hourly earnings growth.
Craig Fehr is a principal and the leader of investment strategy for Edward Jones. Craig is responsible for analyzing and interpreting economic trends and market conditions, along with constructing investment strategies and and asset allocation guidance designed to help investors reach their financial goals.
He has been featured in Barron’s, The Wall Street Journal, the Financial Times, SmartMoney magazine, MarketWatch, the Financial Post, Yahoo! Finance, Bloomberg News, Reuters, CNBC and Investment Executive TV.
Craig holds a master's degree in finance from Harvard University, an MBA with an emphasis in economics from Saint Louis University and a graduate certificate in economics from Harvard.