U.S. equities fell (-3.0% for the S&P 500) for the seventh straight week. The DJIA fell for the eighth week in a row, the longest losing streak since 1923. The S&P 500 briefly dipped into 20+% decline territory, the traditional definition of a bear market. Multiple bearish themes dominated the dialogue. Three sectors were up for the week: energy (+1.4%), healthcare (+0.9%), and utilities (+0.4%); worst sectors were consumer staples (-8.6%) and consumer discretionary (-7.4%).
The Federal Reserve signaled its focus is on taming inflation without flagging the big economic costs this will entail. As long as this is the case and markets believe it, we don’t see the basis for a sustained rebound in risk assets. We think the Fed will consider the costs to growth at some point, especially if inflation cools, and expect a dovish pivot later this year. China’s slowdown is a large shock that will be felt over time. We are further trimming risk and downgrading Developed Market equities to neutral.
The Fed stepped up its rhetoric last week by vowing to bring inflation down at any cost. We think reality will be more complex. First, supply-driven inflation implies the sharpest policy trade-off in decades: between choking off growth via sharply higher rates or living with supply-driven inflation. Second, this trade-off is even more stark amid a weaker global macro outlook. The hit to Chinese growth is starting to rival its 2020 shock and already surpasses the one from the global financial crisis. See the chart.
We think this will reduce growth in major economies and nudge up Developed Markets inflation at a very inopportune time when higher inflation is already proving more persistent. We had already seen Europe at risk of recession, which prompted us to reduce risk a few weeks ago. As a result, we further downgrade Developed Market equities to neutral from overweight.
The Fed’s hawkish pivot this year has been stunning, and pronouncements on reining in inflation have become regular fare. Chair Jerome Powell just last week said the Fed would keep hiking rates until inflation is “tamed” – a comment that dismisses any trade-off or the lagged effect of monetary policy on the economy. The Fed now appears to be constraining itself to the hawkish side of policy options with such language, just as talking about the jump in inflation being “transitory” last year boxed it in when inflation proved more persistent and forced a sharp pivot. We think the Fed could be forced into another sharp pivot later this year, which we expect rather than a recession. These Fed pivots are driving market volatility, in our view.
Market expectations are now calling for the Fed funds rate to zoom up to a peak of 3.1% over the next year, more than doubling since the start of the year. For the European Central Bank, market pricing reflects four hikes this year and getting to nearly 1.4% next year, well above our estimate of neutral and for an economy at real risk of stagflation this year. The equity selloff this year makes sense from this perspective – if you believe that the market’s view of the Fed and ECB rate paths are right.
The growth reality will be more complex – both from the policy trade-off it faces amid a deteriorating macro backdrop, especially China’s slowdown, and Europe facing stagflation. That’s why we expect a dovish pivot later in the year. We stick to our view of the Fed raising rates to around 2.5% by the end of this year – and then stopping to evaluate the effects. We still see the U.S. economy’s momentum as strong – we expect growth of around 2.5% this year, slightly below consensus and far from recession. Equities may have short-term, technical rebounds. Yet until the Fed starts to pivot, we don’t see a catalyst for a sustained rebound in risk assets. The upshot? We further reduce portfolio risk after having trimmed it to a benchmark level a few weeks ago with the downgrade of European equities. We are now neutral on Developed Market equities, including U.S. stocks. But a dovish pivot by the Fed would spur us to consider leaning back into equities. Our change in view prompts us to keep an overweight to inflation-linked bonds from a whole-portfolio perspective. We prefer short-term government bonds for carry, and see scope for long-term yields to rise further as investors demand greater term premium for the risk of holding such debt in this inflationary environment. Overall we remain underweight U.S. Treasuries.
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. Data provided by Refinitiv.
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