If a year ago, anyone suggested that the US Federal Reserve, the world’s de fact central bank, would produce a triple rate hike, and that this rate hike would be celebrated with a 5% rally in equities, they would probably be laughed out of the room. Yet, last week capped one of the best monthly performances for the S&P 500 in more than two years, despite the US central bank’s aggressive tightening.
The equity move inform investors of two things:
Expectations management matters. The rally is not attributed to the rate hike, but to the Fed’s suggestion that it is reaching the ‘neutral rate’. This might not mean as much as investors hope for. The ‘Neutral’ rate, is where rates should be in a ‘normal’ economy. It does not equal the ‘Terminal’ rate, the peak of the cycle. At 9% inflation, the terminal rate could be much higher. Instead of reading too much into this economic theory number, the real bullish signal is absence of meaningful quantitative tightening, i.e. siphoning money from markets.
The Fed successfully tested the market’s Pavlovian responses, proving that money supply is still the ‘only game in town’ for the pricing of risk assets. However, investors should not take the short-term market reaction for proof that the previous economic paradigm is intact. The US economy is close to a recession. For lower incomes and Small-Medium Enterprises it certainly feels like one. Global supply chains are in disarray and labour markets are tight. Thus, economic output could remain suboptimal while inflation could linger enough to de-anchor long term consumer expectations, and drive a wage-growth vicious inflation cycle.
While economic performance does not equal market or corporate performance, correlation is high. At their core, equities are shares of a company’s profit. Bonds represent the ability of companies and nations to pay their debts. In a recession, these profits may be squeezed. Higher rates don’t facilitate debt refinancing and could expose weaker borrowers. Despite the Pavlovian rally in equities, parts of the bond market continue to look stressed.
Investors should remain laser-focused on fundamentals, like valuations and cash flows. That’s what matters right now.