Dow Jones Fell, US Stocks Crashed?
On one side is the high inflation, on the other side is the incomparably tough attitude of the Federal Reserve, on the other side is the rising risk of recession, U.S. stocks in the end or collapse, the Federal Reserve announced on the 16th to raise interest rates by 75 basis points (BP), the S&P 500 in the past week officially entered the bear market area, from January 3 of this year’s record highs fell 24% to 3667 points. The difference is that this crash has left no desire to bottom, as the “Fed Put” is hardly working anymore. The Dow Jones closed 29888.78 down 38.29.
The so-called Fed Put, that is, investors are counting on the Federal Reserve to rescue the market at the time of the crash, that is, to release liquidity and lower interest rates, which is like you buy a put option, even if the stock market falls, you will be protected. This was actually tried and true in the aftermath of the 2008 financial crisis and at the time of the March 2020 epidemic collapse. The difference is that the Fed’s target of less than 2% inflation at the time has now froze to 8.5% (U.S. CPI in May), and it’s not going down for a while.
“My electricity bill has gone up a lot, gasoline prices have gone up a lot, and it’s twice as expensive to fill up my car compared to last December (Brent crude prices are up 60% since the beginning of the year, and the average price of finished gasoline in the U.S. is up 50%).” A U.S. stock trader complained to the author. In his opinion, U.S. stocks are still quite a distance from the bottom. But in fact, no one can figure out where the bottom is this time.
How tough will the Fed be?
In an effort to curb inflation, the Fed took the biggest hike in nearly three decades at its June meeting, announcing a 75BP rate hike to raise the target range for the federal funds rate from 0.75% to 1.00% to 1.50% to 1.75%.
At the press conference, Fed Chairman Powell reassured the market that a 75BP rate hike would not be the norm, and that the next hike could be 50 or 75BP. there was no shortage of traders who thought future rate hikes would exceed 1%.
In fact, the FOMC had hinted at the May meeting that a 50BP rate hike in June would be appropriate, but it would also depend on data performance. After seeing the higher-than-expected May CPI and the University of Michigan Consumer Inflation Expectations Index on June 10, the Fed suddenly changed its mind. To suppress inflation expectations should be done before it’s too late, so a 75BP rate hike came into play.
Goldman Sachs expects the Fed to continue to raise rates by 75BP in July, then 50BP in September, and another 25BP each in November and December, thus accelerating the return to a neutral policy stance of 3.25% to 3.5%. The futures market now expects a 219BP tightening over the next 12 months.
Currently, the Fed’s own forecast is for rates to end FY2022 at 3.4%, meaning another 165BP hike this year; rates are expected to be 3.8% in 2023, which is essentially the same as the market’s expectations (4%). But who can not say whether this rate hike is expected to further strengthen, after all, even the former chairman of the Federal Reserve Bernanke said at the end of last year, the Fed may not raise interest rates for the first time until the summer of 2022, when he even thought that the rate hike before 2023 is unnecessary.
All in the face of inflation
Price stability and full employment are the Fed’s statutory missions. The current job market is unbelievably red, while price stability is in tatters. The Fed will certainly do whatever it can to preserve its credibility, even if the price of suppressing inflation is triggering a recession.
This time, the Fed raised its inflation forecast to 5.2% in 2022 and is expected to be 2.6% in 2023. The Fed believes that inflation will remain high this year, while it may fall back to its target level of about 2% by 2023. However, this prediction is not very convincing, after all, in 2021 the Fed is also holding the attitude of “waiting for inflation to fall naturally” to do nothing, and now is much criticized, is considered too late to raise interest rates.
Fed Chairman Powell also pointed out in a press conference on the 16th that the Fed is facing two worsening factors, one is the supply chain dilemma lasts longer than expected, and the second is the Chinese epidemic sealing control initiatives. It is worth noting that the Fed this time also mentioned concerns about overall inflation (accounting for food and energy prices), while earlier the Fed’s concern was only core inflation. It is evident that the Fed’s concerns are starting to be in the same channel as the market.
What is the current situation of inflation in the United States? In fact, the local people in the United States have long felt the huge pressure of inflation from the soaring electricity, gas and postage costs. And according to the U.S. Bureau of Labor Statistics, almost all major sub-indicators rose in May from a year earlier, with the largest contributions coming from emergency housing, airline tickets, used cars and trucks, and new cars：
the housing market is facing a shortage of supply and a high level of demand；
airfares are recovering from the low base created by the epidemic；
Used car and truck prices have been high for some time due to, among other things, the downturn in the new car industry (economic recovery in the latter part of the epidemic, poor supply chains and an apparent lack of supply of semiconductor chips). Dealer inventories can only be absorbed for 21 days, compared to 63 days before the epidemic. However output levels are now rising.
We can say that these effects will diminish over the next six months or so and that inflation will be below its current record high by mid-2023. But “permanent” inflation includes an “expected” element, and inflation is hardly only temporary. The conflict between Russia and Ukraine has already exacerbated the strength of this shock.
Will there be stagflation or recession?
Stagflation and recession are key words that have been mentioned in the market recently. The market is concerned that the Federal Reserve may curb inflation at the cost of a recession, i.e. by sharply tightening liquidity and raising interest rates as a way to dampen consumer demand and thus pull down inflation.
The S&P 500 has fallen 24% to 3667 points from its all-time high on January 3. Unlike the tech-dominated Nasdaq (which has always been the most sensitive to interest rates), which fell over 30% just before, the S&P 500 brings together what are considered to be the 500 highest quality companies in the world, all of which have now collapsed.
The US economic cycle is still in the stagflationary phase and has not yet entered the recessionary phase (downward inflation overlaid with a downward economic spiral), so from the performance of US assets, the current phase is still a stock and bond double kill, not yet entered the stock down and bond up phase.
Looking back at history, there have been 11 bear markets in US equities since 1950. According to Goldman Sachs, after entering a bear market, Dow Jones usually falls for another 1-2 months before bottoming out. In these bear markets, the median peak-to-trough decline is -34%. In the 4 bear markets where there was no recession in the following 12 months, the median return 6 months after falling into bear market territory was +16%. In the next 7 recessions, the median 6-month return for the index was -7%.
In addition to the prospect of declining earnings, valuation contraction is a key factor hitting U.S. stocks right now, and the larger the rate hike, the faster the valuation contraction. The Morgan Stanley U.S. equities team mentioned two weeks ago — assuming relatively stable valuations, the lion’s share of stock returns would be determined by earnings growth. However, they are far from stable and often unpredictable. Valuation has two components – the 10-year Treasury yield and the equity risk premium (ERP). The current ERP is only 295BP, which is 75BP lower than the agency’s current fair value estimate. Given mounting evidence of slowing growth and risks to earnings, that forecast could rise even further, which is why the agency sees the S&P 500 as likely to hit 3,400.
At present, the mainstream consensus is that the S&P 500 will fall by at least about 10%, but it is difficult for anyone to predict whether there will be a moth in the future.
A senior U.S. stock trader also recently told the author that the S&P 500 index will likely continue to decline, and may first hit 3,500 points, which is the 50% Fibonacci of the March 2020 low to the early 2022 high. Retracement. There will be some support around 3400, but the S&P 500 may first fall to around 3400-3500.
At the same time, the Nasdaq index has fallen the most at present, and it has risen the most before. The index has fallen by 50% of the gains since the epidemic. The index could then hit 10,500, the 61.8% Fibonacci retracement level of the March 2020 low to the early 2022 high. If the Fed raises rates more, the Nasdaq could come under more pressure and the decline could continue into the fall. The Nasdaq’s 200-week moving average is around 10,800, and it’s just one step away from falling below it.