The stock market and the economy part ways

The U.S. economy expanded at the fastest rate since 1984 in the fourth quarter of 2021. GDP grew by 6.9% at an annualized rate. At the same time, depending on which average you cite, the stock market is down between 10 and 20%. What gives?

Many investors just can’t figure out how the two can be going in such different directions at the same time. While some on Wall Street don’t quite understand why this is happening, Chairman Jerome Powell and the members of the Federal Reserve Bank certainly do.

At this week’s FOMC meeting, Chairman Jerome Powell made it clear that the Fed was ready, able, and willing to start raising interest rates as soon as March. And he didn’t rule out the possibility of raising rates faster, further, and more frequently in the months ahead.

Powell assured the financial audience that policy makers were more than willing to act as needed to cool the highest inflation the nation has experienced in 40 years. He also said that the Fed would start to shrink its balance sheet after rate increases begin.

The traders over in the U.S Treasury bond market immediately started pricing in more rate hikes for this year. So far, a total of five interest rate hikes are now expected. The amount and speed of monetary tightening telegraphed to traders that the Fed is far more concerned with the inflationary impact on Main Street and the economy than the impact it might have on financial markets and Wall Street.

Those holdouts who were looking for the Fed to deliver a less hawkish message were obviously disappointed. The message couldn’t have been clearer. The “Fed Put” has been removed from the market and investors are now on their own.

Many investors make the mistake of looking at what the Fed did during the last rate hike cycle starting back in 2015 through 2018 as a model for what the Fed will or will not do today. History, they point out, would say that the Fed will back down from raising interest rates if stocks continue to fall, just like they did during other temper tantrums. I believe they are missing an important difference between now and then.

As Powell pointed out during the Q&A session after the FOMC meeting, the economy, inflation, and the labor market were in a different situation. Back then, GDP growth was in the 2-3% range. Inflation was below 2%, and unemployment was higher than it is today. At the same time, savers’ retirement funds had just recouped most of the losses incurred during the Financial Crisis.

In hindsight, the tightening of monetary policy back then was directed toward normalization. That is, removing the Fed’s influence on the economy through a process of massive monetary easing that had been built up since the Financial Crisis. In a sense, the Fed had a weaker hand at that time.

Their withdrawal of monetary influence from the markets was considered a marginal effort that would over time return the Fed’s balance sheet to a more manageable size.  However, any downside to the economy, or the employment rate, as a result of this process was more than enough reason to pause. At the time, the stock market that was still recovering from 2008-2009 period, was also a factor.

At times, the economy and the stock market are in sync, but sometimes they are not. Clearly, the price level of stocks can impact business and investments decisions. Households can also be affected, since much of their wealth can be invested in stocks as part of their retirement plans. But they are not in sync today. The economy has lagged the gains in the stock market for some time.

Today, the Fed is facing something much more serious than mere normalization. A 7% inflation rate demands action.  In addition, the Fed is in a much stronger position to raise interest rates without any real concern from any potential fallout from a declining stock market. After huge gains over the last few years in the stock market, a 20% drop in valuations might hurt, but not necessarily crimp, real activity by consumers. As for the credit markets, they have barely budged during the market’s decline thus far in 2022.  That is a big difference compared to 2015 and then again in 2018.

Unemployment is below 4%, the labor market is tight, and the economy, even if it slows a little, is still way above historical growth rates. Balance sheets around the nation, whether you are looking at the states, or the consumer, are in good shape. The Fed, in my opinion, is not going to be swayed by further declines in the stock market. Those looking to be “saved” and therefore buy the dip are going to be disappointed.

As we enter February, I still see further downside in the markets. In terms of price performance, Apple came in with record earnings, but its results just couldn’t support the market as it has in the past. Sure, we can bounce. If, as I expect, we get good earnings in the coming week from Google or Amazon, the markets may rally for a day to up to a week, but in the face of rising interest rate expectations, the trend is still down. I am expecting the S&P 500 Index to fall to the 4,060 area before all is said and done. 

Bill Schmick is registered as an investment advisor representative of Onota Partners, Inc., in the Berkshires.  Bill’s forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners, Inc. (OPI).  None of his commentary is or should be considered investment advice.  Direct your inquiries to Bill at 1-413-347-2401 or e-mail him at bill@schmicksretiredinvestor.com .Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal.