The drawdown in the S&P 500 in 2022 was largely due to high inflation and the Fed’s very aggressive rate hiking response. Continued increases in the market’s expectation for the peak fed funds rate were a constant source of pressure on stocks. Indeed, that was the primary driver of the sell-off in equities today, on the heels of Fed Chair Jay Powell’s testimony to Congress in which he suggested that the Fed would likely raise rates higher than they had previously expected.
From this perspective, the equity market bounce off the October low, was in part, driven by a flattening out in peak rate expectations, at least for a few months. With some observers calling for the Fed to raise rates to as high as 6%, additional increases in the peak rate cannot be ruled out. Still, the Fed is getting closer to the end of its hiking program and at some point in the coming months, this risk will fade. After we reach this point, it's possible that equity markets could drift higher, especially if economic data remains resilient.
But that doesn’t mean stocks are out of the woods. While the inflation and Fed risks may be receding, we are still concerned that the lagged effects of Fed rate hikes could show up later this year in the form of weaker- than-expected economic growth. We have been watching employment in housing construction very closely. Employment in this segment is still rising despite very weak housing activity. Why? Homebuilders have been burning through elevated backlogs. But if new home sales don’t pick up, which seems unlikely given very poor affordability, then employment in this industry could begin to soften. Housing is important because it has big multiplier effects across the economy.
Furthermore, the notion that there are still risks in the back half of the year also aligns with the signal from the inverted yield curve. The yield on the 2-year Treasury first exceeded the yield on the 10-year Treasury in March of last year (a yield curve inversion). Historically, it takes about 18 to 20 months for a recession to develop after the yield curve inverts. This suggests that recession risks may become more pronounced around the fourth quarter.
So overall, the next several months could be a tricky environment where the soft landing (on the back of easing inflation and Fed risks) may look more likely than the hard landing (because it will still take some time for economic growth to appear troubling). Given this possibility, we think it is helpful to stay focused on the risk / reward for US stocks. In a soft landing we think US equities could rise by about 10% by year-end. But in a hard landing, stocks probably have 20% downside. Our December S&P 500 price target of 3,800 implies that stocks are slightly lower by year-end, but the range of outcomes remains wide.
Main contributors: David Lefkowitz, Nadia Lovell, Matthew Tormey
Content is a product of the Chief Investment Office (CIO).
Original blog - Timing is everything, 7 March, 2023.