Finally, investors have a good reason why the US stock market will suffer above-average volatility and below-average returns this month: It’s the Fed.
I say “finally” because market analysts for weeks have been looking for a reason to bet that 2022 will see a repeat of September’s famous seasonal trend of being bad for the stock market. A week ago, I described September’s historic weakness as an “unsolved mystery.”
Reading: What history says about September and the stock market
Sure, the mystery remains for any year other than 2022. But there’s no mystery about what the Federal Reserve will do this month: In addition to continuing to aggressively raise interest rates, the U.S. central bank will significantly accelerate the rate at which its balance sheet is reduced.
At the very least, this double tightening is expected to increase market volatility. Kent Engelke, chief economic strategist at Capitol Securities Management, focused on this consequence in a note last week to clients: “To state the obvious, markets and the economy are entering an era that no one has yet experienced. In addition, due to lack of experience, mistakes will be made. One trader described today’s Fed policy as “driving 60 MPH over ice and pulling on the emergency brake.”
“ The Fed’s double tightening will lead to losses in the stock market. “
It stands to reason that the Fed’s double tightening will lead to losses in the stock market. Relatively few advisors focus on this outcome — at least of the more than 100 I follow regularly. This means that the negative impact of the double tightening may not yet be fully priced into stock prices.
Even fewer advisers are focused on the central bank tightening now happening worldwide. Vincent Deluard, director of global macroeconomics at StoneX Financial, wrote in a note to clients this week that “the Swiss National Bank and the PBOC [People’s Bank of China] have begun to aggressively shrink their bloated balance sheets. Even the formidable Bank of Japan has shrunk its balance sheet by ¥17 trillion since June, and shrinking the ECB’s balance sheet is the next logical step for an institution that has lagged so far behind rate hikes.”
Another reason to suspect that the Fed’s double tightening has not yet fully priced into stock prices is that in recent years there has been a close contemporaneous correlation between changes in the Fed’s balance sheet and the S&P 500 SPX.
As you can see from the accompanying chart, the S&P 500 rose significantly in the wake of the Fed’s bullish balance sheet in March 2020 — and struggled in 2022 as the Fed’s balance sheet growth began to level off.
That’s troubling given that the Fed’s balance sheet hasn’t actually gotten much smaller. it has simply stopped growing at the previous rate. That is about to change, as Deluard notes: “Quantitative tightening will double to $95 billion a month in September. The jump will be even bigger as QT has been delayed this summer: the Fed’s balance sheet has shrunk by $63 billion since QT began on June 1, about half the promised pace. Additionally, the recent jump in mortgage rates has reduced prepayments, so the Fed will likely need to actively sell mortgage-backed securities to meet the $35 billion monthly limit, rather than passively let them roll off the balance sheet her”.
It’s a bad sign that the stock market has already fallen this far in the wake of a modest decline in the Fed’s balance sheet. This suggests that equity markets are more addicted to monetary easing than ever before. It’s scary to think how much pain it will take to cure shopping of one’s addiction.
Mark Hulbert is a regular MarketWatch contributor. Its Hulbert Ratings tracks investment prospectuses that pay a flat fee to be reviewed. It can be reached at firstname.lastname@example.org
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