Even if the Federal Reserve can accomplish the difficult task of cooling high inflation without plunging the economy into a ditch, that doesn’t necessarily mean the markets will be off the hook.
Stocks and bonds have already had a difficult start to the year, before the Fed launched its monetary policy tightening cycle in earnest. Next week, the central bank is expected to pull the trigger on its first half-percentage-point rate hike in more than two decades and begin shrinking its balance sheet by nearly $9 trillion.
The Fed’s efforts are aimed at mitigating the rising cost of living, now at its highest since the early 1980s before a recession set in, but higher interest rates and tougher financial conditions stringent could also mean more pain on Wall Street.
“Much of the discussion seems to be around whether the Fed can achieve a ‘soft landing’ for the economy,” said David Del Vecchio, co-head of investment-grade US companies at PGIM Fixed Income, per phone. “It seems really difficult in this environment where they are really behind.”
With Goldman Sachs pricing the chance of a recession at 35% over the next 24 months, Del Vecchio said “the likelihood of markets selling off is even higher.”
Stock market carnage
Stocks ended an even lower April on Friday, with both the Dow Jones Industrial Average DJIA,
and the S&P 500 SPX index,
registering their largest monthly percentage decline since March 2020.
The ongoing carnage in once high-flying tech stocks has helped push the S&P 500 index back into correction territory for the second time in 2022, while putting the Nasdaq COMP composite index back,
a 13.3% drop in April, its biggest monthly drop since October 2008.
“The S&P 500 rode” the rally as a handful of big tech companies helped corporate America post record profits last year, Don Townswick, director of equity strategies at Conning, said by phone.
“Unfortunately, that’s going to drag those stocks down a bit,” he said. “The market has become very dependent on these companies for its direction.”
Additionally, a hawkish Fed will keep pressure on growth stocks, Steve Chiavarone, senior portfolio manager and equity strategist at Federated Hermes, said in a client note Thursday.
While there may soon be “tactical opportunities” in tech and related growth stocks given their recent hard sell off, Chiavarone warned that “valuations continue to tighten”, mainly due to rising prices. rate.
Bonds often touted as stable, boring and low-risk investments also capitulated, with highly rated U.S. corporate bonds posting their worst performance since the collapse of Lehman Brothers in 2008.
“Total returns have been much more negative than what we’ve been used to for a very long time,” Del Vecchio said.
Goldman analysts pegged total returns over the year at -12% for investment-grade U.S. corporate bonds, the debt issued by many Fortune 500 companies.
Spreads in the sector, where premium bonds pay on risk-free Treasury yields to help offset default risk, have also widened by around 50 basis points (see chart) from year lows. last.
“The backdrop was so good that spreads were able to tighten to very rich levels,” Del Vecchio said. Recent levels appear closer to “fair value”, he said, but thinks they could fall further given the uncertainty surrounding the path of rate hikes, geopolitics and plans to reduce the balance sheet from the Fed.
“I think you want to be selective here,” he said. “Because, given that the potential trail to a recession is quite long, that means you’re likely to have rallies by then. And you should probably think carefully and use those rallies, if they happen, to reduce the risks.