Inflation makes the risk of recession greater. Yet, the medicine the Fed wants to apply - ever higher rates - may have painfully little impact on inflation. Global markets keenly await what comes next.
- The sharpest
about facein Fed policy in modern history has propelled a record large combined drop in equities and fixed income, with both US stocks (as measured by the S&P 500) and long-term US Treasuries falling more than 10% in the last six months for the first time ever. The forward returns for the 10-year US Treasury note were higher after all five periods when both stocks and bonds fell together. The returns for US equities were higher in only three of the five. This is why we believe
Bonds are Back.
- With the economy facing supply shortages, a recession will not bring the war in Ukraine to a more rapid conclusion, nor the end of the pandemic. We fear that the Fed’s medicine, applied too quickly, may engender a hard landing for the economy, while not lowering inflation that quickly.
- With corporate profitability far above trend – EPS gained 47% last year – profits are vulnerable to retrenchment. A drop in profits in 2023 has become more likely. This fear of a decline in corporate profits is one factor driving the sharp decline in equities. This is why we are not inclined to relax our defensive bias in equity markets now. We are overweight essentials such as pharmaceuticals and cyber-security providers.
- We also believe that growth equities in essential, durable demand areas will eventually feel relief from valuation pressures as government bond yields peak. Innovation is continuous while markets have notable periods of euphoria and panic.
- Though the Fed cannot control the speed that inflation will fall, the Fed will determine the rate at which the economy will slow. While we are hopeful they will use forward looking analysis to determine their interventions, markets are watching closely to see if the fight against inflation is going to be harsh or more thoughtfully engineered.