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

(22/09/2022)

1. FRB decided to raise interest rates by 0.75% at FOMC

US stocks plummeted following the recurrence of the CPI shock on the September 13 and then were forced to search for lower prices due to concerns of monetary tightening. Although the S&P 500 index is higher than the year-to-date low (3666 points) on June 16, the market is wary of downswing. US bonds also fell and long-term interest rates (10-year bond yields) climbed to over 3.5%, the highest level in about 11 years since April 2011 (September 20). Under these circumstances, the FRB (Federal Reserve Board) decided to raise the interest rate by 0.75% at the FOMC (Federal Open Market Committee) held on the September 20 and 21. Although it was the third consecutive meeting of significant interest rate hikes, rate hike remained within the range generally expected by the market. Chart 1 shows the trends in US stocks (S&P 500), policy interest rates (the target upper limit for the FF interest rate) and long-term interest rate since 2015. Compared to the previous interest rate hike (December 2015 ~ December 2018), the steeper pace of the recent interest rate hike has caused the bearish stock price. The latest economic and interest rate outlook (dot chart) was also announced At this FOMC, and the policy interest rate was revised upward to 4.4% at the end of 2022 and 4.6% at the end of 2023. At the press conference, FRB Chairman Powell reiterated the hawkish stance of emphasizing the inflation control that he had announced at the Jackson Hole meeting (August 26). On September 21, US stocks rose and fell based the FOMC results and the press conference. However, the major stock indexes continued to fall due to the strong stance of the financial authority to implement monetary tightening even if they have tolerated the economy downturn.

2. US recession probability increased after consecutive rate hikes

The perspective that the US economy will enter a recession emerged due to the FRB’s tightening of monetary policy in response to inflation. Therefore, in Chart 2, I would like to focus on the “recession probability” (market forecast average) for major countries projected by private economists in Chart 2. “Recession Probability Forecast in 1 year” is shown in descending order. Russia has the highest probability of recession at 90% due to economic sanctions stemming from the Ukraine war, followed by the UK (78%) and Germany (60%). On the other hand, we can see that the current “Recession Probability in 1 year” for US has increased by 35% from 15% at the end of last year to 50%. Setting aside whether or not the NBER (National Bureau of Economic Research) will fall into a severe recession that will be officially judged after the fact, the view that the US economy will follow a slowdown trend toward 2023 is gaining momentum. increase. Setting aside whether or not US will fall into a severe recession that the NBER (National Bureau of Economic Research) makes an ex-post and formal decision, the US economy is expected to slow down towards 2023.

In fact, short-term interest rates (2-year bond yields) and long-term interest rates reverses (inverted yields), and there are growing voices that the US economy is heading into recession. Since the short-term interest rate, which is sensitive to policy interest rate trends, has reached 4%, while the long-term interest rate, which is sensitive to future business sentiment and inflation expectations remains at 3.5%, the difference (long-term and short-term interest rate spread) has expanded to about 0.5% (21 days). Some markets see the risk that the inverted yield, a key part of the bond market yield curve, will widen to levels since the early 1980s (1% = 100 BPS) as the recession approaches (Bloomberg News report). To what extent will the FRB continue to raise interest rates and maintain tight monetary policy in order to curb inflation, even if it sacrifices the economy to some extent? It is getting clear that the stock market is wary of concerns about the future of the economy and earnings uncertainties that will affect total demand.

3. US stocks tend to rise “the year before the presidential election”

However, even with some twists and turns, I expect inflation to ease gradually. Long-term interest rates may stabilize or decline from the end of the year to next year if the prospects for the policy interest rates become clear. On the other hand, after the midterm elections to be held on November 8, election trends in the US Congress are expected to be close (between the Democratic Party and the Republican Party). With the next presidential election in 2024, the Biden Democratic Party may shift the focus of economic policy from “controlling inflation” to “boosting the economy”. In fact, there is an anomaly (market seasonality and trend) showing that “US stocks tends to be bullish in the year before the presidential election (the year after the midterm elections)” in the US election cycle (4 years). Chart 3 shows the average changes of the NY Dow Jones Industrial Average over the past 10 presidential elections (beginning of the year=100). In the year before the presidential election, the Dow Jones Industrial Average grew steadily and rose about 16% on average for the year. With the presidential election coming up the next year, it is strongly believed that the incumbent president (at that time) aggressively implemented (on average) measures to support the economy and stimulate the economy, leading the stock market to perform well. The monetary tightening so far indicated that the economy may enter a recession in 2023. However, in addition to stabilizing the long-term interest rates to reduce the inflation, fiscal stimulus led by the White House (President’s office) is favorable. Thus, I would like to pay attention to the possibility that US stock prices will rise again in 2023. American writer Mark Twain famous quote said, “History doesn’t repeat itself, but it often rhymes.” It means, “History never repeats exactly the same, but similar events often occur.” Assuming a scenario that “US stocks will recover next year”, I believe that “buying on decline” and  “bargain hunting” are appropriate investment strategies when stock prices fall within this year.