As bear market looms, battered Wall St seeks elusive ‘Fed put’
The Federal Reserve’s determination to raise interest rates to squash the highest inflation in decades is darkening the outlook on Wall Street, as U.S. stocks sit on the cusp of a bear market and recession warnings mount.
At stake is the Fed’s so-called put option, or investors’ belief that the Fed will take action if stocks fall too low, even though it doesn’t have a mandate to support asset prices. An oft-cited example of the phenomenon, named after a hedging derivative used to hedge against market declines, occurred when the Federal Reserve halted a rate-hike cycle in early 2019 after a tantrum in the US market. values.
This time, the Fed’s insistence that it will raise rates as much as necessary to rein in rising inflation has bolstered the argument that policymakers will be less sensitive to market volatility, threatening more pain for investors.
A recent survey by BofA Global Research showed that fund managers now expect the Fed to enter 3,529 in the S&P 500, compared with expectations of 3,700 in February. Such a drop would constitute a 26% drop from the S&P’s Jan. 3 closing high.
The index, which closed Friday at 3,901.36, is already down almost 19% from that high this year on an intraday basis, close to the 20% drop that would confirm a bear market, by some definitions.
“The Fed has bigger fish to fry and that’s the problem with inflation,” said Phil Orlando, chief equity market strategist at Federated Hermes, who is adding to his cash levels. “The ‘Fed put’ is kaput until the central bank is sure it is no longer behind the curve.”
As a result, some investors are looking a long way. The BofA survey showed cash allocations at their highest point in two decades, while bets against tech stocks are at their highest point since 2006.
Meanwhile, Goldman Sachs strategists earlier this week released a “Recession Playbook for US Stocks” in response to client queries about how stocks will perform in a downturn. Analysts at Barclays said numerous short-term negative catalysts mean risks to the stock “remain firmly stacked to the downside.”
The S&P 500 closed largely unchanged on Friday, reversing a sharp intraday decline that had briefly put it into bear market territory. The index marked its seventh straight week of losses, the longest streak since 2001.
Jason England, portfolio manager of global bonds at Janus Henderson Investors, believes the index needs to fall at least another 15% for the Fed to scale back its tightening as unprecedented monetary policy support helped stocks higher. double from its March 2020 lows.
“The Fed is being very clear that there will be some pain ahead,” he said.
The Fed has already raised rates by 75 basis points and is expected to tighten monetary policy by 193 basis points this year. Investors will learn more about the central bank’s thinking when the minutes of its latest meeting on May 25 are released.
2018 REDUCTION?
Some worry that the Fed risks exacerbating volatility if it fails to heed potential danger signals from asset prices. Analysts at the Institute of International Finance said stocks may be subject to the same kind of selling that rattled markets in late 2018, when many investors believed the Fed tightened monetary policy too much.
“In the past, rising uncertainty and rising recession risk have had major effects on investor psychology, making markets less forgiving of monetary policy tightening that is no longer seen as warranted,” the analysts wrote. of the IIF on Thursday. “The risk of a similar tantrum in the market (through 2018) is rising again now that markets worry about the global recession.”
There have been signs of resilient sentiment among investors. For example, the Cboe volatility index, known as Wall Street’s fear gauge, is elevated but below the levels it reached during previous major sell-offs.
And the ARK Innovation Fund, which became an emblem of the pandemic rally, has generated positive net income of $977 million in the last six weeks, data from Lipper showed. The fund is down 57% in 2022.
While some investors say those are signs the markets have yet to bottom, others are more hopeful.
Terri Spath, chief investment officer at Zuma Wealth, believes some investors are re-entering parts of the stock market that have suffered outsized losses.
“The Fed is already seeing signs that they won’t be needed as a buyer of last resort,” he said.
Deutsche Bank analysts are less optimistic.
“The Fed erred seriously on the side of excess inflation in 2020/21, can’t afford to make the same mistake twice, which favors further tightening of financial conditions and ongoing high (volatility) panicked markets,” they wrote.