We argued that one of the key market questions for 2022 will be whether the Fed can engineer a soft landing for the economy – policy tightening to rein in inflation and bring growth back to trend without risking a recession.
It obviously depends on the Fed, but just as important is how economic fundamentals have evolved this year. President Jay Powell said so during his press conference on Wednesday. It’s a safe bet that the Fed will raise rates at the March FOMC, most likely by 25 basis points, with another hike in June and possibly May as well, and announce in 2Q the start of the rate cut. balance sheet. But after this 1H takeoff, the Fed’s outlook becomes murkier. By summer, it will be able to assess the impact of its 1H actions, with more data on supply chain improvements and easing inflationary pressures.
The market expects almost five bulls in 2022, with the risk tilted towards more, not less. Even if inflation moderates to around 3% as most economists expect, the case for further hikes is that the Fed has met its inflation and employment targets, so it should adopt a neutral policy on as quickly as possible. But how fast the Fed wants to get there is uncertain. We will have a better idea in March after the Fed updates its summary of economic projections and its “dot chart” of rate hikes. It will take very large revisions in both to suggest the Fed wants to go into neutral even in 2023, let alone this year. So, it’s entirely possible that the Fed will look less hawkish six months from now than it does now.
Regardless of what exactly the Fed ends up doing, this is a very different macroeconomic regime for investors than what they are used to. Indeed, monetary policy is now a source of volatility, instead of removing it from the markets. This reinforces the importance of economic fundamentals as market drivers. With that, we make two final points.
First, analysis of US economic data this year amounts to a Rorschach test for investors’ market outlook. For example, retail sales were well below expectations in December and the 4Q21 GDP report showed a sharp rise in inventories, which bears see as evidence that end demand is weakening. Whether that is because inflation is squeezing consumers or because fiscal expansion has come to an end is secondary. The bullish reading of this data is that the cooling in demand and the replenishment of inventories point to an easing of inflationary pressures. Additionally, omicron has distorted the data, which will improve as the wave fades. Although we favor the bullish interpretation, it will take a few months or more before either side’s view is validated.
Second, the Fed has a somewhat indiscriminate impact on asset class returns – easing/tightening tends to benefit/harm all asset classes – thus driving the level of absolute returns up and down. In contrast, economic fundamentals do not cover such a wide web and therefore have more relevance to the relative performance of asset classes. Consider that the S&P 500 is down nearly 7% year-to-date, while Eurozone stocks are down 4%. The sell-off in growth stocks due to higher rates is disproportionately hurting US returns. But it’s also true that European economic data is currently surprising to the upside versus the downside in the US, and European earnings revisions are near a 5-year high versus the US. So just as the Fed will closely monitor economic fundamentals to inform its policy decisions, investors should do the same when making asset allocation decisions.
Main contributor -Jason Draho
The content is a product of the Chief Investment Office (CIO).
Read the original blog – Fed vs FundamentalsJanuary 31, 2022.
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