- Last week’s equity rally was almost surely a bear market rally.
- Peak inflation may have passed, but several underlying drivers remain in place, making it likely that inflation settles at a level well above the Fed’s 2% target.
- After the Fed pauses, rates could remain high, and rate-driven headwinds will increasingly be a drag on growth and earnings.
- We expect another downward leg in this bear market.
- Investors should take advantage of the rally to reduce exposure to equities.
Don’t Get Your Hopes Up
Last Thursday witnessed a massive equity rally. The S&P 500 shot up 5.9%, and the NASDAQ 100 was up 8.8%. If you think that marks the end of this bear market, then you also believe:
- Peak inflation has passed, and the Fed will soon pause its rate hike campaign.
- Inflation will fall steadily, allowing the Fed to start cutting rates.
- The economy remains healthy and will not approach or enter recession.
- Alternatively, the Fed put is alive and well, and the Fed will blink at any sign of economic weakness as it has so many times before.
Barring some new energy shock or geopolitical crisis, inflation has almost surely peaked. Some pandemic-related inflation drivers are easing. Used car prices are finally falling. Supply chain pressures have largely dissipated. Energy prices have stabilized.
The Underlying Problems Are Still There…
But other underlying inflationary forces will hardly abate soon.
- Near record low unemployment is inflationary. People are making money and spending it on goods and services. Indications are that demand is outrunning supply. And tight labour markets mean upward pressure on wages.
- The Ukraine war is inflationary. Historically, Ukraine provides 10% of global wheat and 15% of global corn production. Many of those crops are off the market now, keeping pressure on food prices.
- The economic war with China is inflationary. There is the loss of cheap labour and the costs of moving production facilities to another country or the US. There is the loss of trade and the efficiencies that go hand in hand.
- Shelter costs – a third of CPI – will keep rising given the chronic housing shortage in the US.
These kinds of factors make it likely that inflation will settle in at a level far above the Fed’s 2% target, perhaps around 4-5%. Again, that assumes no new major shocks.
…So the Fed Has a Long Row to Hoe
In that scenario, the Fed will remain in inflation-fighting mode for the foreseeable future, perhaps indefinitely. Even if it soon stops raising rates, it is likely they will remain high, in the 4-5% range, until inflation cools.
The likely impact will be a steady drag on the economy, or a steady headwind that at some point induces a recession. It may be impossible to slow inflation much further without pushing unemployment higher and thereby cutting demand and wage pressures.
Will the Fed blink? For most of the past 30 years when it did blink, inflation was not a big factor. But as long as inflation is a serious problem, it will likely take a major crisis for the Fed to exercise that put.
To put it another way, if the Fed does blink, things are likely in bad shape and investors will be worrying about far bigger problems rather than hoping to benefit from near-term monetary policy.
The Bear Is Still With Us
We view this as a bear market rally. Powerful as it was, equities remain firmly within the trading range of the past five months (Chart 1).
We expect those rate-driven headwinds to start rising in coming months. Worries about recession risk will increasingly come to the fore. In this environment, any upside for equities is limited, and more likely they will trend downward. Should earnings start to fall or the economy falter (e.g., the unemployment rises), we will likely see another meaningful downturn in equities.
We would take advantage of this rally to position for a downturn.
- Reduce exposure to equities.
- Buy medium-term puts on the SPX index.