The best hope for stocks right now is a recession that crushes inflation and allows the Fed to slow, stop or even reverse rate hikes.
Why it matters: Down 20.5% so far in 2022, it's the ugliest year for the S&P since 1962.
- The drop vaporized $9 trillion in paper wealth, delivering a psychological shock to millions whose retirement is mostly in stocks.
Driving the news: Facing persistent inflation, the Fed delivered its largest rate hike since 1994 on Wednesday.
- The increase is the monetary-policy equivalent of stomping on the country's economic brakes — sharply increasing the risk that growth contracts.
- Despite the recent beating shares have taken, the Fed's announcement was greeted with open arms by investors. The S&P 500 rose 1.5%. The Nasdaq rose 2.5%. Interestingly, the Russell 2000 — which is more closely tied to short-term ups and downs of the economy — rose less, at just 1.4%.
The big picture: A huge rate hike that raises the risk of recession may sound like a bad thing for stocks — but with inflation still rising, it isn't.
- Essentially, investors are saying they prefer a big, sharp Fed-induced economic shock now if it quickly gets inflation under control. In theory, that could allow lower rates to return after inflation is vanquished.
- Low interest rates have been crucial to the performance of stocks over the last decade.
Context: While Americans have a habit of looking at the stock market as an economic indicator, the linkage between economic growth and stock market performance is surprisingly weak, and, some academics say, nonexistent.
The most extreme example of this reality arose during the bleakest moments of the COVID-related recession.
- In April 2020, the U.S. economy was essentially on life support. Unemployment that month was 14.7%. There were, quite literally, bread lines miles long.
- That month the S&P 500 posted its best month in 33 years, rising nearly 13%.
What gives? Well, in late March 2020, the Federal Reserve had to cut interest rates to zero and restart money-printing programs do deal with the COVID crisis. (The Federal government also began dumping what would ultimately be trillions of dollars into the economy to keep people afloat.)
- Those actions supercharged stock prices.
The intrigue: But don't recessions hurt corporate earnings? Wouldn't that make stocks fall?
- Earnings are one ingredient in stock prices, and they can definitely fall during recessions. But recently, interest rates — essentially the yield on the 10-year Treasury note — have played a more important role in establishing stock prices than earnings.
- That's because those interest rates largely determine the valuation multiple — otherwise known as a price-to-earnings ratio — investors use to determine the price they're willing to pay for those future earnings (effectively, the price of a stock).
- TL;DR: Higher rates = lower valuations, and vice versa.
- So, even if earnings are expected to fall, stock prices can still rise, if valuations rise enough. Those valuations are largely determined by interest rates — and those rates are largely determined by Fed decisions.
The bottom line: The sooner people think the Fed can stop raising interest rates, the better it will be for stocks.
