It's a lot of turmoil and gloom, especially since I've often been in this camp and believe that I don't how the Federal Reserve will be able to increase interest rates without dwindling the US economy back into recession. I believe the base case is that a reversal to negative growth might not happen in 2022. There's a small window that the Fed will really have to thread the needle.
The housing market is slowing. Consumers are showing signs of changing their spending patterns due to rising inflation. The FANG stocks are breaking down. It's possible that another 10-15% decrease would not be all that surprising.
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If you haven't already, check out my newsletter from a few weeks ago, where I will outline it in 2022.
However, there is still a scenario in which stock exchanges are showing a sharp rise, with prices rising again.
For the record, this is a low-profile event in the near future, but it might even happen towards the end of the year. I'm not saying this will happen soon or even at any time. I'm just pointing out the scenario that I believe would see the bulls return to the equity markets.
The Fed has made an unexpected dovish move in this situation.
We know that the Fed is in full inflation control mode. This is precisely what we are seeing today. We know that since the 2-year Treasury yield has risen from 0.25% to about 2.65% today, the market is pricing nearly 250 basis points of Fed rate rises. Today, the markets are as hawkish as they have been at any point during this cycle and will remain that way unless something changes the narrative.
I believe the Fed will continue to push rates higher once they have established it. It is willing to let the economy bend, but it does not want it to break. However, the central bank has seen the loop in the last quarter of 2018 when the Fed was on a tightening path, and the threat of a European recession caused a quick reaction from the central bank. If it does, chances are it will.
These are two "dovish pivot" scenarios, one of which I think it must be played out in order to get the stock market back on track.
The markets are concerned about inflation above all else, but the core inflation rate reading that came down somewhat below expectations did indeed indicate peak inflation for the United States. In fact, inflation begins to decrease significantly than predicted. China's reopening from its recent COVID closure reduces some of the pressure on supply chains. Energy and commodity prices rise and begin returning down to earth.
The Fed has no longer needs to price in an aggressive rate hike schedule and Treasuries are finally bottom. Investors are optimistic that we can battle this current inflation scare while keeping GDP growth in positive territory. However, the economy continues to deal with some of the fallout, but experts say that recession will be avoided, inflation will return to the Fed's target, and risk asset prices can begin the reflation process.
Powell believes that the Fed's monetary tightening strategy would result in a recession that the markets predicted. Stocks are falling and inflation is taking longer than expected to get under control. The effects of the Russia/Ukraine war looms, and supply chain gaps are still causing problems.
The Fed effectively decides to terminate its laser focus on inflation and pivots to at least a partial focus on reaping growth. Rate increases are done and the markets begin pricing in rate cuts instead. Short-term rates fall on a more dovish Fed and long-term rates rise as investors feel less need for safety trades.
I don't think these are scenarios that have a chance of playing out at least until the 2nd half of 2022 and perhaps longer. The Fed will not receive any information within the next several months that will improve its mind on rate rises, therefore don't be surprised to see a Fed Funds rate of around 2% by the end of July.
The central bank does have the authority to modify the narrative. In 2018, its dovish pivot reintroduced the S&P 500 to new highs within four months of fixing, although it was dovish pivot in 2020 during the COVID shutdown (trillions of dollars of stimulus money also helped here) helped the S&P 500 recover all of its 30%+ decrease within five months. It might very well happen again!
Sector Crash in ETF
Let's look at the markets and some ETFs together.
There are three clear leaders in the equity market right now - utilities, consumer staples, and real estate. All three have been steadily outperforming the market for about a month now, but haven't yet shown signs of slowing down. As we prepare for the Fed's May meeting, these sectors will continue outperforming.
Is the party over for energy stocks? It's certain that the sector has now underperformed the market since late February and today's 6% decline is showing a near-term sentiment shift. Crude oil prices are coming back down and natural gas was reduced by 11% last week. The materials industry, also a good proxy for the commodities space, finally underperformed last week. Investors who invest in energy thinking they can capture past gains might be so droolish.
Treasuries are steadily increasing in response to the Federal Reserve, but I think we're in early stages of things turning around. Treasuries, as a safety trade, are also becoming more important because to the fact that investors are starting to see them as a safety trade again. If that's the case, and the reversal we've seen in stock markets may become more common.
The number of subsectors within growth stocks is very low. Communication services are still underperforming at the moment, but Facebook, Alphabet, and some of the traditional telecoms were all diminishing once more. Are valuations getting a little attractive once again following the recent pullback? It's clear that the mega-cap earnings reports coming this week should provide some guidance.
It'll be interesting to see if technology starts making a comeback here. If Treasury rates continue to drop, we might see tech start to outperform the wider market again. Not necessarily, though, but at least outperform the S&P 500. Reduced rates are good for growth stocks, and there's a possibility that we start seeing that again here.
Both of this year's top markets are starting to see a dramatic reversal. The miners have been one of the best trades throughout 2022, but it's conceivable that the rally will be over at least in the long-term. If the Fed continues to push rates sharply higher and the economy progresses toward recession, there may be more room to fall for precious metals.
Banks are looking weak, but at least they had a good week last week. All of the lending information, especially mortgage application statistics, suggests that a significant slowdown in the housing market is coming. The homebuilder stocks are already down 30% this year, and slower lending activity is going to hit the bottom line. The big banks have gotten good about diversifying their revenue streams, but the smaller regional banks may have a difficult time.
Utilities and real estate are looking relatively strong here in the last three months, but they have performed quite impressively. I think a pullback might be in place, but investor sentiment is still strong in favor of these groups.
The yen and the yuan are both falling. The euro and the British pound are the only currency in town. In the forex market, the greenback is really the only game in town. It was a difficult week for commodities and industrial metals across the board, but lumber prices are still swinging around. Last week they increased, and they remain very volatile.