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Too Soon to Price in the Bottom

  • Even though investors are increasingly betting on a softer Fed, there is little evidence to suggest that policymakers are prepared for any dramatic pivot within the foreseeable future.
  • Markets and investors hate uncertainty and with the Fed determined to keep investors guessing at the conclusion of every policy meeting, there is nothing other than an abundance of uncertainty on the horizon.

A commonly held view in the market is that picking bottoms is difficult, so investors should just make sure they have sufficient dry powder to bet on the upswings.

And while it’s true that no previous market selloff was preceded by a global pandemic, the case for more volatility ahead versus a durable rebound is still relevant.

July’s rally in global equities rolled into a far more humdrum August, and history is replete with examples of protracted selloffs peppered with invigorating rallies.

But July’s rally was special in that it was only the sixth time since the end of the Second World War, where the benchmark S&P 500 regained everything it lost in the previous month and then some, with the other five incidences on October 1974, October 2002, March 2009, January 2019 and April 2020.

In those previous episodes where the S&P 500 staged a furious rebound, it would then go on to average gains of 30% in the ensuing 12 months.

But the last five times the S&P 500 had a big reversal as it did in July, the U.S. Federal Reserve had already slashed rates aggressively, this time the central bank is hell bent on dealing with inflation by hiking borrowing costs.

And even though investors are increasingly betting on a softer Fed, there is little evidence to suggest that policymakers are prepared for any dramatic pivot within the foreseeable future.

Last year, when U.S. Federal Reserve Jerome Powell was actively selling the theory that inflation was “transitory” the central bank was behind the curve and caught flat-footed when price pressures remained stubbornly durable.

The Fed has now swung to the opposite extreme instead, with Powell conceding that failure to restore price stability would be a “bigger mistake” than pushing the U.S. into a recession, which he believes that the U.S. can still avoid.

What is more likely though is that in trying to avoid the Scylla of recession and the Charybdis of inflation, the Fed will likely achieved neither and instead reintroduce the “stop-start” policy approach that was disastrous in the 1970s and 1980s before a fresh Fed chairman stepped in and stuck to his guns.

Markets and investors hate uncertainty and with the Fed determined to keep investors guessing at the conclusion of every policy meeting, there is nothing other than an abundance of uncertainty on the horizon.

That the language and posturing of the Fed after its last meeting shifted away from a clear path of supersized rate hikes was the respite, however brief, that investors may have been looking for.

But make no mistake about it, because policy operates with a lag, even if actual inflation has slowed, just as in 2021, policymakers are likely to behind the curve when it comes to rate-setting as well and could underestimate the risk of triggering a recession.

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