The Disinflationary Impact Of Fed Policy On Equities
2022.05.17 13:21
The disinflationary impact of Fed policy on equities is coming. There is currently much debate in the mainstream media suggesting investors should ignore Fed rate hikes. To wit:
Fed Rate Hikes And Markets LPL
Such is a pretty compelling argument on the surface to stay the course with portfolios. However, as is always the case, every market cycle is different. Let’s look at a chart of Fed rate hiking cycles from 1980 to the present.
Fed Funds vs Crisis
Historically, Fed rate hikes have consistently led to poor outcomes for investors. However, since the Fed policy takes about 9-months to impact the economy, LPL’s chart doesn’t show you
Furthermore, out of the last 8-rate hike cycle, 80% of them occurred during the secular bull market cycle that started in 1980. During that 20-year cycle, the deregulation of the financial industry led to a massive debt-driven consumption boom, combined with consistently falling inflation and interest rates.
Even with those tailwinds, the Fed managed to create crisis after crisis by hiking rates.
QE Is Disinflationary For Stocks
Here is another problem for the thesis.
For the last decade, the primary bullish thesis for chasing equity markets remains While the are adamant that you shouldn’t when monetary policy is loose, as evidenced by LPL, they say the same when it reverses.
However, logic would dictate that outcomes can not be different UNLESS the changes to monetary policy have NO impact on equity pricing. That was a point previously made by Minneapolis Fed President Neel Kashkari who once stated that the Fed’s QE program does not affect the financial markets.
While he may be as noted, there is ample evidence of a direct impact on financial markets. As discussed in “Past Performance Is A Guarantee:”
Fed Balance Sheet Vs S&P 500 Correlation
The inflation of assets was not isolated in the U.S. but globally.
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Global Equities To Central Bank Balance Sheet
Given the high correlation to asset prices, logic suggests any contraction of the Fed’s balance sheet is disinflationary.
Fed Balance Sheet Reduction Schedule
That contraction is coming, and if correlations hold, the disinflationary impact on equity assets should logically follow.
Selling Rallies
As noted, monetary policy has a lag effect of about 9-months before it becomes evident in the markets and economy. As shown, with market sentiment so extremely negative, a market rally is certainly possible.
Composite Sentiment Indicator
NAAIM Exposure Index
However, as my colleague Albert Edwards recently noted:
Notably, while discussing the disinflationary impact on equities such does not necessarily mean a There is certainly a possibility the U.S. could avoid a major bear market as long as global inflows continue at the current unprecedented pace.
US Vs Non US Flows
Unfortunately, history suggests that such an optimistic outcome is rarely the case, given higher rates, less monetary accommodation, and slower economic growth.
QT Now, QE Later
While many believe the Fed will hike rates in their quest to battle inflation, that fight will end quickly when arises. As Former Dallas Fed President Richard Fisher noted:
“
How would such a dramatic turn occur?
- At 20%, margin calls will begin to rise, putting pressure on asset and high-yield credit markets. (Such may have already started as witnessed by recent actions.)
- Yield curves will fully invert as the market declines by 25% and economic growth crashes.
- At 30%, corporations will lay off workers and move to protect profitability.
I suspect, as noted above that somewhere between a 20-30% decline, we will see the Fed return its focus to
Selling rallies certainly seems to be the prudent course of action at this stage of the equity cycle.
