August 22, 2022 Dave Wigginton

The market has started to show signs now that it Is beginning to believe the Federal Reserve and its rate hike intentions. While I know the Fed hasn’t always been the most credible, I’ve wondered why investor consensus was so adamantly in denial with inflation levels at 40+ year highs and the Fed being as outspoken as it has been about its rate hike ambitions. I’m sure some of it has to do with the perception the Fed presidents are merely jawboning in an attempt to persuade market participants to do the tightening heavy lifting for the Fed. This game of chicken is dangerous though as the Fed may end up being forced to follow through with its stated intentions if conditions don’t tighten sufficiently, raising rates well above where the market is currently expecting. This action could obviously lead to a series of negative and unpleasant consequences.

I’ve considered other possible explanations/scenarios for investor incredulity. Some of the more prevalent considerations follow.

  1. The market believes inflation is not as big of an issue as maybe it is and will come down to more acceptable levels without too much more stress. The proverbial soft landing would be a great outcome for most investors (sorry bears) but has only occurred 15% of the time during tightening cycles, according to David Rosenberg. While certainly a possibility, it doesn’t seem like it should be the base case for the current environment.
  2. The Fed is limited in how high it can raise rates given US government debt levels and commitments to Social Security and Medicare. This theory seems reasonable to me given current interest expense and entitlement promises as a percentage of government revenues. Under this scenario, inflation would theoretically be higher for longer. It doesn’t seem like there is much market buy in for this scenario currently as future inflation expectations don’t appear to reflect such an outcome.
  3. The Fed’s planned quantitative tightening (“QT”) will be sufficient to get inflation under control. I know certain analysts have extrapolated the equivalent of the Fed’s QT in terms of interest rate hikes. I don’t know how valid the analysis is, but regardless it is a form of tightening. Is it possible the expectations for rate hikes combined with planned QT are sufficient to bring inflation down?
  4. A recession is inevitable given the tightening to date and on the come, which will cause the Fed to pivot. The recession will lead to declines in earnings growth, which will lead to lower stock prices. There seems to be a lot of support for this thesis among institutional investors. The rally in stocks over the past several weeks would seem to contradict this view.
  5. Higher inflation and rates aren’t going to crash the economy as has been relentlessly hyped. Additionally, a recession is not inevitable. I find this scenario very intriguing given the amount of people expecting a recession and other doom and gloom scenarios. It seems there’s an expectation that financial conditions need to return to “the norm” of the past 10 years or so for the market to stabilize and resume any sort of uptrend. I can understand why that’s a convenient narrative. More Fed involvement, modest economic recovery and growth, and a very strong stock market. Perhaps the economy and stock market are on more stable footing than we give them credit for. There was a lot of concern about the economy and housing market perpetually struggling after the financial crisis, yet things continued to improve and go up. Sure, there were bumps along the way but none of the doomsday scenarios so many people were forecasting in the subsequent years to the financial crisis ever materialized. Rational investors must at least consider this scenario as a potential outcome today.

I’m increasingly of the opinion it’s going to take a lot more rate hikes than expected, a dramatic decline in earnings growth, and/or another crisis (perhaps sovereign debt?) for stocks to decline meaningfully from here. In other words, a currently unexpected worsening of conditions is likely necessary for a big drop in stock prices from here.

The truth is nobody knows what’s going to happen or when it’s going to happen. All market participants are trying to do their best to handicap potential outcomes and invest accordingly. No one will necessarily ever be “right”. They will simply be well-positioned for whatever happens and/or will adapt accordingly. Being right in investing isn’t a singular event. It’s a process of planning, executing, being disciplined, and being consistent no matter the bumps along the way. Process over time versus a single or series of outcomes is what makes the difference.