Bottom or bear market?  What stock market investors need to know about stagflation and the Fed

Bottom or bear market? What stock market investors need to know about stagflation and the Fed


It will take more than Friday’s big jump to allay fears in the bear market, as uncertainty about the Federal Reserve’s ability to control inflation without sinking the economy is fueling fears of stagflation – a pernicious combination of slow economic growth and persistent inflation.

Stagflation is a “terrible environment” for investors, which usually leads to stocks and bonds losing value at the same time and causing confusion with traditional portfolios divided 60% into stocks and 40% into bonds, said Nancy Davis, founder of Quadratic Capital Management.

This was already the case in 2022. Bond markets lost ground as government bond yields, which are moving in the opposite direction to prices, soared in response to inflation, which is the highest in more than forty years, along with expectations of aggressive tightening of monetary policy by Fedu. Since the close of the S&P 500 index on January 3 this year, stocks have been slipping, leaving the benchmark of large capitalization on the verge of formal entry into the bear market.

iShares Core US Aggregate Bond ETF AGG,
-0.43%
decreased by more than 10% year-on-year by Friday. It follows the Bloomberg US Aggregate Bond Index, which includes government bonds, corporate bonds, munis, mortgage-backed securities and asset-backed securities. S&P 500 SPX,
+ 2.39%
in the same period it decreased by 15.6%.

The situation leaves “virtually nowhere to go,” Montreal-based analysts PGM Global wrote last week in a note.

“Not only are long-term government bonds and investment-grade loans moving almost one-to-one, but long-term government bond sales are also more likely to coincide with the days of decline in the S&P 500 index,” they said.

Investors looking for consolation were disappointed on Wednesday. The eagerly awaited April consumer price index in the US showed that year-on-year inflation slowed to 8.3% from a peak of more than four decades in 8.5%, but economists were looking for a sharper slowdown and basic data to get rid of volatile food prices and showed unexpected monthly growth.

This underscores fears of stagflation.

Davis is also the portfolio manager of the IVOL Hedge Exchange-Traded Fund, a quadratic fund for interest rate volatility and inflation.
+ 0.69%,
with about $ 1.65 billion in assets to hedge against growing fixed income volatility. The fund holds inflation-protected securities and is exposed to the difference between short-term and long-term interest rates, she said.

The rates market is currently “very complacent,” she said in a telephone interview, signaling expectations that raising the Fed’s interest rates would “create a disinflationary environment” when tightening is unlikely to solve supply-side problems. which are plaguing the economy as a result of the coronavirus pandemic.

Meanwhile, analysts and traders discussed whether Friday’s stock market recovery heralded the beginning of the bottom process or was only a reflection of oversold conditions.

“After a week of strong sell-offs, but with inflationary pressures easing close to the border and the Fed still seems to be paired with an increase of 50 basis points for each of the next two [rate-setting] At the meetings, the market was prepared for a type of strong endemic rally that will carry market rallies, “said Quincy Krosby, chief equity strategist at LPL Financial.

It was quite a bounce. Nasdaq Composite COMP,
+ 3.82%,
which slid into the bear market earlier this year and fell to almost 2 1/2 years last week, jumped 3.8% on Friday to its largest one-day percentage gain since November 4, 2020. This shortened its weekly decline to still significant 2.8%.

The S&P 500 rebounded by 2.4% and cut its weekly decline by almost half. As a result, the large-capped US benchmark fell 16.1% from its record close in early January after ending just before a 20% withdrawal on Thursday that would meet the technical definition of a bear market. Dow Jones Industrial Average DJIA,
+ 1.47%
increased by 466.36 or 1.7%, a weekly decrease of 2.1%.

Read: Despite the rebound, the S&P 500 is moving dangerously close to the bear market. Here is the number that counts

And all three major indices are experiencing long, weekly series of losses, with the S&P 500 and Nasdaq each falling for six weeks in a row, the longest stretch since 2011 and 2012, respectively, according to Dow Jones Market Data. The Dow recorded its seventh consecutive week of losses – the longest series since 2001.

The S&P 500 has not yet formally entered the bear market, but analysts do not see a lack of bear behavior.

As Jeff deGraaf, founder of Renaissance Macro Research, noted on Wednesday, correlations between stocks ranged from the 90th to the 100th decile, meaning that performance indicated that the stock traded mostly in unison – “one of the defining characteristics of the bear market.”

While the S&P 500 has moved “uncomfortably close” to the bear market, it is important to keep in mind that large stock market declines are normal and frequent, analysts said. Barron’s noted that the stock market has seen 10 bear market declines since 1950 and a number of other corrections and other significant declines.

But the pace and scale of the recent recovery may, of course, leave investors shaken, especially those who have not experienced a volatile decline, said Randy Frederick, executive director of trading and derivatives at the Schwab Center for Financial Research, in a telephone interview.

The rally saw “every single sector of the market went up,” he said. “This is not a normal market,” and now the worm has turned as monetary and fiscal policies tighten in response to hot inflation.

“It’s not fun now,” he said, but “that’s how real markets work.”

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