The Bearish S&P 500 Thesis
Here is the historical fact: there were 13 Fed’s interest rate hiking cycles since 1945 – and 10 out of 13 times a recession followed. Exceptions: 1994-95, 1983-84, 1965-66.
I in detail why the Fed will not be able to engineer the soft-landing this time around like in 1995. In summary: inflation was never a problem during the 1993-1995 period because globalization was disinflationary and made the soft landings possible. The current unfolding trend of accelerated de-globalization is stagflationary and makes the soft landing virtually impossible.
The Fed is currently signaling a very aggressive monetary policy tightening, which I think will cause a recession and a bear market, like in the other 10 historical cycles. This is the bearish () ( ) thesis. However, when making the stock market predictions (and acting on them) it’s absolutely necessary to understand the counter thesis – the bullish thesis.
The Counter Thesis – The Bullish Thesis
I closely follow the research of major financial institutions, and I found the most coherent bullish thesis on US stocks from BlackRock. Here is the latest commentary from April 18th:
: Strategic (long-term) and tactical (6-12 month) views on broad asset classes, April 18th, 2022.
- Directional view on equities (BlackRock):
We increased our strategic equities overweight in the early 2022 selloff. We saw an opportunity for long-term investors in equities because of the combination of low real rates, strong growth and a change in valuations. Incorporating climate change in our expected returns brightens the appeal of developed market equities given the large weights of sectors such as tech and healthcare in benchmark indices. Tactically, we favor developed market equities over emerging market stocks, with a preference for the U.S. and Japan over Europe.
- Tactical views on US equities (BlackRock):
We overweight U.S. equities due to still strong earnings momentum. We see the Fed not fully delivering on its hawkish rate projections. We like the market’s quality factor for its resiliency to a broad range of economic scenarios.
Essentially, BlackRock does not believe that the Fed will “walk the walk” despite the hawkish talk. BlackRock believes that the Fed will increase the interest rates quickly to the neutral level, and at that point allow the higher-than-targeted inflation to persist. In their view, we will all have to learn to live with a higher inflation. Thus, stocks are essentially the preferred investment in this environment as an effective hedge against inflation (tactically over shorter term and strategically over the longer term). In other words, BlackRock believes in the soft-landing scenario and that the Fed put is still firmly in place. In their view, growth will remain strong, and real interest rates will remain historically low. This is the bullish S&P 500 thesis.
Fed’s “Talk The Talk”
Fed Chairman Jerome Powellat the IMF that the central bank is committed to raising rates “expeditiously” to bring down inflation. Also,
“It’s absolutely essential to restore price stability,”
“It is appropriate in my view to be moving a little more quickly”
“I also think there is something to be said for front-end loading any accommodation one thinks is appropriate. … I would say 50 basis points will be on the table for the May meeting.”
These are extremely hawkish comments and imply a very aggressive monetary policy tightening. Accordingly, Nomura Holdings Inc. nowthe Federal Reserve “to lift interest rates by 75 basis points at both its June and July meetings, moves that would follow up on an expected 50 basis point hike in May.” Stock market bulls could be in a rude awakening the Nomura is right.
The Fed’s Credibility
But will the Fed actually follow up on these signals? Will the Fed “walk the walk”? I strongly believe that yes, the Fed will have to implement the signaled aggressive policy tightening to restore its’ credibility.
More specifically, on the same day when the Fed Chair Powell made these extremely hawkish comments, the long-term inflation expectations, as proxied by the 10Y Breakeven inflation expectations, exceeded 3%, which is the highest mark on the record.
Thus, longer term inflation expectations are de-anchoring as the Fed “talks the talk”, implying the market does not believe that the Fed will actually “walk the walk” – which is consistent with the BlackRock thesis. The Fed has no inflation-fighting credibility – the market is conditioned to believe that the Fed’s primary mandate is to protect the stock market.
The problem is, given the trend of accelerated deglobalization, the inflationary pressures are here to stay – don’t expect a quick solution to the supply-side issues. Runaway inflation could have a very serious social and political ramification. Thus, the Fed will be forced to restore its credibility to re-anchor the long-term inflationary expectations, which is only possible by severely curtailing the demand – and causing the shock to the stock market.
S&P500 () is still overvalued at the ttm PE Ratio near 24 and the forward PE ratio near 19. Market analysts, such as BlackRock, still expect the Fed to primarily protect the stock market via the Fed put.
They don’t realize that the game has changed. The Fed put is an effective tool in a deflationary environment when the Fed aims to boost demand via the wealth effect – a rising stock market boosts confidence and demand via increases in wealth.
But we are not in a deflationary environment now – we are now facing de-anchoring long term inflationary expectations amid the 40-year high CPI inflation. Thus, the Fed now has no need for the wealth effect. In fact, the Fed has to curtail demand to fight inflation – and falling asset prices will actually help.
Thus, S&P 500 is likely in an unfolding bear market since January 2022, with a long way to go – given only a modest current drawdown of 6-7%.