Background of US stocks adjustment: Process of incorporating the monetary tightening

 Written by:  Mutsumi Kagawa (Chief Global Strategist, Economic Research Institute of Rakuten Securities)

(15/04/2022)

 

1.  Markets are wary of accelerating inflation and tightening monetary policy

Due to the prolonged crisis between Ukraine and Russia and concerns over the tightening of US monetary policy, US stocks are facing massive headwinds. Mester, President of the Federal Reserve Bank of Cleveland said on April 10, “Although we are confident that the economy will not face recession despite tighter monetary policy, inflation will remain above 2% this year and even next year.” In fact, the US CPI (Consumer Price Index) for March, announced on the April 12, accelerated to +8.5% (+7.9% in February) from the same month of the previous year. However, business sentiment and oil demand slow down due to the lockdown in China, the crude oil market (WTI futures) has stagnated, and it seems getting closer to the peak of inflation. Under these circumstances, the outlook for the Fed Funds rate has risen by the end of 2022 and the end of 2023, incorporating the upward trend of the policy interest rate in the futures market (Chart 1). There are increasing views that the rate hike will increase to 0.5% at the next FOMC (Federal Open Market Committee) in May, and there are also observations that QT (Quantitative Tightening) will be imposed. US bond yields rise reflecting these situations. 10-year bond yields temporarily exceeded 2.8% this week, and 2-year bond yield temporarily reached the 2.5% level. Considering the favourable employment environment, it is likely that the US economy will avoid recession and make a “soft landing”. However, U.S. stocks appear to be in the process of incorporating the intensifying monetary tightening by authorities.

 

<Chart 1: Futures market expects a rising trend in policy rates>

(Source) Created by Economic Research Institute of Rakuten Securities, Inc. from Bloomberg (Beginning of April 2021 – April 13, 2022)

 

2. The FRB’s total assets declines, but the Ukrainian crisis is also a positive factor for the US

In the US market, the hurdle to implement the QT awaits along with the observation that the Fed Funds Rate will increase. In the March FOMC minutes summary released on the April 6, almost all participants suggested that “(QT) should be decided at the next FOMC (May 3-4) at the earliest.” It was generally agreed to reduce the total asset balance up to $ 95 billion (about 11.9 trillion yen) a month. It is possible that the market is overly cautious of this “contraction of liquidity” (deterioration of supply and demand in the bond market). Chart 2 looks back on the changes in the stock price (S&P 500 index) and the FRB’s total asset balance, which has grown to about $9 trillion (about 1125 trillion yen) for the purpose of dealing with the Covid-19 pandemic since 2007. Looking back on the relationship between the two, even though the FRB has expanded its total assets in response to the recession and the sharp decline in stock prices, there are no signs of the stock market entering a bear market in the process of shrinking total assets.

 

<Chart 2: Total asset balance of FRB is decreasing>

(Source) Created by Economic Research Institute of Rakuten Securities, Inc. from Bloomberg (Beginning of 2007 – April 8, 2022)

 

Regarding the Ukraine-Russia crisis, I would like to pay attention to some tailwinds in the US economy. For example, the strong crude oil market, which is also a symbol of inflation, is a positive factor in terms of exports to US, which is the “world’s largest producer of crude oil”. Regarding the rise in the market price of agricultural products such as wheat, US is the 4th largest wheat producing country in the world after China, India and Russia, and may benefit from the rise in the market price of agricultural products. In addition, Russia’s military invasion is expected to significantly change the world’s power balance and increase defense spending. In Europe, the policy is to increase defense spending, led by Germany. Lockheed Martin, Raytheon Technologies and other major defense-related companies in the US are the major sources of armament demand. The benefits of the US industries cannot be ignored due to the Ukraine-Russia crisis. The recent strength of the US dollar in the foreign exchange market may have factored in this tailwind for the US economy.

 

3. Check out the potential risk factors which domestic and foreign markets are facing

As I explained earlier, I believe that “even after the rate hike cycle, US stock prices will eventually return and follow the pace of improvement in the business outlook.” It is hoped that inflationary pressure due to supply constraints will subside for that purpose. Although the pace of the global economy expansion is expected to slow down slightly due to the Ukraine-Russia crisis, the real GDP growth rate of the US is expected to continue to grow at +3.3% (market forecast average) in 2022, following the year-on-year increase of 5.7% in 2021. S&P 500 Index based 12-month forecast EPS is expected to increase by 20.4% year-on-year to 235.95 (average market forecast as of April 8). I believe the stock market will make an interim rebound in the process of transitioning from the financial market to the performance market. However, the easing of inflationary pressures may be delayed depending on the improvement of supply constraints that cannot keep up with the recovery of demand from the Covid-19 pandemic. In this case, it affects the process of normalizing monetary policy, and there is also risk that the stocks will be temporarily volatile. In addition, “potential risk factors” that may be vulnerable to the stock market are not merely inflation and interest rate risk. Chart 3 is a list of risk factors that are likely to pressure on stock prices downward in the second half of 2022. All of these are potential risk factors that are beyond the scope of association. But when each event becomes apparent, be wary of situations that force to adjust stock prices. Depending on the magnitude of the influence of such potential risk factors, it is undeniable US stocks in 2022 may be more volatile than 2021. While keeping these risk factors in my mind, I would like to prepare for “buying on decline” and “bargain hunting” flexibly and anticipate long-term strong trends.

 

<Chart 3> Potential risk factors for the second half of the year (list)

(Source) Created by Economic Research Institute of Rakuten Securities, Inc.