The abrupt shift in Fed policy – from easy to an increasingly tighter stance – has reintroduced volatility to markets. What drove the shift? Inflation. Instead of inflation easing into the back half of 2021, it picked up steam. There are good arguments on both sides of the inflation outlook (see our Q4 Focus for a deeper dive). Goods’ prices have experienced strong price pressures, and this has broadened out recently; a combination of continued supply chain pressures, higher energy prices, and some pass-through of wages are key drivers. On the other hand, higher interest rates and the end of stimulus checks may put a chill in consumer shopping and bidding wars for homes. The Fed, like many other market participants, has been caught off guard by the current high-inflation dynamics. That has forced the central bank to become more “nimble,” in Chair Powell’s words, and to communicate that they will move hard and fast to restore price stability and rebuild their credibility as an inflation fighter.
How did we get to this week’s market gyrations? The Fed relied on their forecasts that inflation would come down – the same forecast that many market participants had – and it turned out to be wrong (at least in 2021). By pivoting to a more flexible, data-dependent approach, they essentially conceded that the idiosyncratic changes to the economy during the pandemic and the incredibly fast nature of this recession to recovery cycle have hampered their ability to predict the future path for the economy. According to the Fed’s newly held view, in today’s environment acting on forecasts could hurt more than it could help. And with inflation currently at 40-year highs, it appears the Fed now believes that it may have to move very aggressively to stamp it out.
In the stock market, ripping off the easy-money band aid certainly hurts, and investors are in the process of separating the wheat (the major indexes) from the chaff (the high momentum areas). Witness the dizzying corrections for The Bloomberg Galaxy Crypto Index – down over 50% from its November 9, 2021 high and the IPOX SPAC Index – off 44% from its high last February to January 27, 2022. The average stock in the Nasdaq Composite Index has experienced a decline of about 47% from its peak, according to a JP Morgan report on January 25, 2022. The aforementioned market sectors are all essentially speculative plays – all valuation and sentiment and little to no earnings.
Viewing stocks through the lens of price-to-earnings multiples (P/Es) – a common equity valuation metric – helps put the recent decline of broad market indices in context. The S&P 500 Total Return Index is down about 10% from its peak on January 3, 2022. As seen in the chart below, its recent declines have been driven by a fall in valuations, not earnings – since the start of the year, the Bloomberg consensus earnings expectations for the S&P 500 Index have actually risen. Stock prices have fallen recently due to a re-rating of valuation multiples as the Fed’s hawkish pivot introduces higher risk and uncertainty, not as a result of falling earnings. Our point is that equity fundamentals remain robust, and the core of the stock market is much more resilient than the ostentatiously frothy areas.