SUMMARY
The US Federal Reserve’s near-term policy decisions will largely determine the depth and duration of this bear market. This bulletin assesses what might happen when markets discount a large drop in profits as well as higher capital costs more appropriately.
- After a 20% decline in US equity markets and a 200-basis-point increase in long-term corporate bond yields, we believe markets discount a severe rise in the cost of capital, but not a major decline in corporate profits.
- We stand between two very different outcomes, one where the Fed induces a recession to fight inflation with resultant job losses and credit issues, and another where the Fed sees
green shoots
in terms of wage inflation, inventory levels and moderating energy prices, and provides time for markets to normalize. - Even though it seems temporary supply shortages are responsible for most of today’s inflation, the Fed’s view is there is a major risk that inflationary expectations are rising and sticky. This is why it is acting swiftly and decisively to
mitigate inflation.
The Fed appears willing to drive a self-reinforcing collapse in the US economy with the goal of bringing inflation lower. - If the Fed pauses rate hikes, there may be some relief in debt costs, but the combined impact of higher capital costs and lower profits will impact markets very differently depending on whether a recession occurs or is avoided.
- How will we know the Fed has gone too far? One sign is an inverted yield curve. The second is a breakdown in credit markets. If credit breaks harshly, history shows Fed easing takes time to make repairs.
