The U.S. Federal Reserve (Fed) and its Chair Jerome Powell managed to say three things the markets needed to hear. First, it finally gave the markets something they have been looking for all year—a forward path for interest rates. The Fed met market expectations for rate hikes this year (seven expected in 2022), which was hawkish but not a surprise as the market had already priced that in.1 Second, Mr. Powell voiced strong confidence in the state of the U.S. economy and pushed back on recession fears. This is something the markets really needed to hear. And third, he retained optionality, stating that every meeting is “live” so policy can be calibrated for risks.2
The question now is, will yesterday’s rally continue in the coming weeks and months? We are a lot more positive than a few weeks ago that this rally may have legs. Here are the reasons why.
As you may recall, we have written in the last few weeks (and most recently here) about what we needed to see to identify a market bottom. Before we were comfortable calling an all-clear on adding risk we needed to see: greater capitulation in positioning and better technical indicators; greater pricing-in of recession fears; and importantly, positive growth catalysts. Today it appears that these conditions may have been met. We have seen:
1) A massive correction in risk sentiment and clearing of positions. For example, hedge fund net leverage is now back to almost March 2020 lows, after massive selling early last week.3 Some risk appetite indicators recently reached lows not seen since December 2018, and 2015/2016 before that.4 This is typically a contrarian bullish indicator in the absence of an imminent recession. Finally, the technical patterns emerging are supportive—we have now tested the area of 4,160 on the S&P 500 three times since late February, and yesterday’s rally pushed us to a higher close than the two previous ones.5
2) Priced-in recession probabilities reaching 40%. Of course, the Fed does not want to alarm the markets by saying that recession risks are elevated, which is why Powell pushed back strongly against it. For now, it seems that recession fears have been paused. However, a recession is possible in 2023 assuming that the Fed follows through on the penciled in 11 rate hikes by the end of 2023, bringing the Fed funds rate to ~2.8%, above the long-run/neutral rate of 2.375%.6 Also, the probability of a recession one to two years out starts to rise when the unemployment rate is low (not high), compensation growth is high, and consumer and manufacturing sentiment is slumping.7 These conditions are in place today, with current indicators suggesting a 40% recession probability on a one-year outlook.8 Recession probabilities based on market measures (the S&P 500 and credit spreads) are also 40% looking one year out.9 However, the markets do not typically peak until much closer to a recession.10 Assuming that recession is not imminent and is pushed out to 2023—which also assumes that commodity prices do not spike again—the markets could perform better from here as they have already priced in a recession probability consistent with that suggested by economic indicators.
3) A willingness to engage in negotiations on both sides of the Ukraine conflict. There is still great uncertainty, but it seems like both sides are open to negotiations. This is progress. Unfortunately, immediate military de-escalation remains unlikely and our thoughts continue to be with people of Ukraine during this unbelievably challenging time. However, for markets, after the initial fear—which drove spot prices for many commodities to near worst-case scenario price levels11—it is becoming clear that the West is not willing to completely cut off the flow of critical commodities for their own economic self-interests. For example, while the United States and the United Kingdom stopped purchasing Russian oil and natural gas, most European counties remain buyers. And metal supplies have so far not been disrupted.12 So even if the conflict continues, commodity prices are unlikely to spike as they did early in the conflict, and equities could rally in relief.
Based on these positive developments, we could have a sustained tradable rally. Of course, the situation could turn on a dime. If we were to see further escalation in Ukraine and sanctions that disrupted commodity flows, commodity prices might spike again. As noted above, this would pull recession risks forward and reverse the positives that have emerged in the last week.
However, it is important to remember that while we may not always get the bottom exactly right, taking a dollar-cost-average approach during periods of market weakness tends to work well over the long term. Buying in times of uncertainty and during pullbacks is a much better approach than buying when valuations are lofty and sentiment strong. Historically, returns from the current positioning levels were positive 96% of the time over the subsequent 12 months, with average returns of 13.4% over that period13, suggesting that the recent pullback has improved the risk-reward calculus for the year ahead.
What should an investor do? Bear in mind that adding risk is not an all or nothing process. We would focus on three things right now:
1) Adding some risk via Nasdaq stocks to take advantage of the 16% pullback from recent highs.14
2) Cleaning up equity exposure during rallies by reducing exposure to cyclical stocks like consumer services and consumer discretionary that are ill-suited to this environment and what’s coming next.
3) Implementing a bifurcated “barbell” approach of tech, energy, and some travel reopening trades on the one hand, coupled with real estate, private credit, and dividend-paying stocks for income to help overcome inflation on the other.
(1) Source: Bloomberg, FOMC Summary of Economic Projections, as of March 16, 2022.
(2) Source: Transcript of Chair Powell’s Press Conference, March 16, 2022.
(3) Source: Goldman Sachs Prime Services, as of March 16, 2022.
(4) Source: Goldman Sachs Risk Appetite Indicator (RAI), as of March 14, 2022.
(5) Source: Bloomberg, as of March 16, 2022.
(6) Source: FOMC Summary of Economic Projections, as of March 16, 2022.
(7) Source: Bloomberg, as of March 16, 2022.
(8) Source: JPMorgan Research, as of March 16, 2022
(9) Source: JPMorgan Research, as of March 16, 2022; Goldman Sachs, March 11, 2022.
(10) Source: Bloomberg, as of March 16, 2022.
(11) Source: Bloomberg, JPMorgan Commodities Research Estimates, as of March 9, 2022.
(12) Source: Source: Bloomberg, as of March 15, 2022.
(13) Source: Goldman Sachs, March 7, 2022.
(14) Source: Bloomberg, as of March 16, 2022.
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