Special Market Update

April 25, 2022

Fed Fright Friday for Stocks

What’s Important

• Investors are digesting tighter-than-expected monetary policy, which should put downward pressure on economic activity and equity valuations.

• Until it isn’t, the current economic backdrop is still characterized by very strong nominal growth (likely +10% Q1 YoY), which is kindling to robust corporate profit growth. Q1 earnings results have exceeded expectations and the trajectory for growth should continue in subsequent periods unless and until a slowdown in real economic activity proves too burdensome.

• Higher-trending earnings help reset the fundamental floor for stocks higher, even as tighter financial conditions put downward pressure on valuations and likely depress upside.

• The current backdrop augurs a more neutral balance of risk across portfolios and more defensive posturing within equity allocations, in our view. But we advise against abrupt decision-making, as exceedingly bearish sentiment is a contrarian positive and history highlights that sharp drawdowns are often followed by strong performance.

Talk about a rough way to end the week for global equities. The S&P 500 ended the week and the day down approximately 2.75% as investors digest a slate of new information that suggests that tighter-than-expected Fed policy might be more burdensome than the real economy can stomach. Since their ultra-hawkish pivot in December, there have been periods of relative calm where investors seemingly doubt the efficacy of Fed action or their commitment to it, but Federal Reserve officials have seemed quite steadfast in their resolve to tamp down on pricing pressures.

To this end, we have consistently detailed the explicit intent of the Federal Reserve to tighten financial conditions, which ultimately pressure the present value of cash flows and the lens through which investors value riskier assets, including stocks. This transmission mechanism is often choppy and episodic, which characterizes recent market movement with periods of relative complacency (misguided in our view) interrupted by volatile spikes and risk-off drawdowns. Meanwhile, the current economic backdrop remains surprisingly buoyant and corporate sector fundamentals even more so. The current trajectory of earnings results from Q1 exemplifies the impressive ability for companies to translate strong nominal growth into revenues and then use operational leverage to drive earnings even higher.

In the near term, we view current market dynamics as a clash between the “unstoppable force” of earnings growth, of which inflation has been a tailwind, versus the “immovable object” of tighter policy. The slow burn of higher earnings should continue to reset the fundamental floor for stocks higher; however, more burdensome financial conditions are likely to depress valuation and cap upside, also increasing the frequency of bouts of episodic volatility. Eventually tighter policy may also weigh on fundamentals. This augers a more neutral balance of risk across portfolios and more defensive posturing within equity allocations, in our view. Lower beta, higher quality and more consistently profitable segments likely offer the most attractive risk-adjusted opportunities. We do caution against rash action, however. Sentiment is exceedingly bearish, positioning may be beginning to turn (net outflows from equity ETFs this week) and historical episodes of sharp short-term drawdowns have often been followed by strong performance thereafter. Balance is advised.

What to Know

• Investors are digesting tighter-than-expected monetary policy, which should put downward pressure on economic activity and equity valuations. Traditional financial conditions in the U.S., as represented by the GS Financials Conditions Index and of which stock P/Es are considered, have sharply increased at the fastest pace in over 20 years outside of recessions. The average 30-year fixed mortgage rate has increased at the fastest clip ever recorded (see Exhibit 2). Meanwhile, soft economic data appears to be buckling.
• Until it isn’t, the current economic backdrop is still characterized by very strong nominal growth (likely +10% Q1 YoY), which is kindling to robust corporate profit growth. Q1 earnings results have exceeded expectations and the trajectory for growth should continue in subsequent periods unless and until a slowdown in real economic activity proves too burdensome.
• Higher-trending earnings help reset the fundamental floor for stocks higher, even as tighter financial conditions put downward pressure on valuations and likely depress upside. We characterize this dynamic as the “unstoppable force” of earnings growth versus the “immovable object” of tighter policy.
• The current backdrop augers a more neutral balance of risk across portfolios and more defensive posturing within equity allocations, in our view. But we advise against rash decisions, as exceedingly bearish sentiment is a contrarian positive and history highlights that sharp drawdowns are often followed by strong performance.

Historical Perspective

The S&P 500 has had 53 prior instances of a -2.75% one-day drawdown since March 2009 and 100 occasions of a one-week loss of -2.75% or more. That does not make such whipsaw events any more enjoyable or nerve calming but we note that these coiled-spring jolts lower have often represented attractive entry points (see Exhibit 1).

Exhibit 1: One-day and one-week drawdown number of episodes

Source: First Republic Investment Management, Bloomberg. Includes data from March 26, 2009, to April 22, 2022.
Past performance is not indicative of future results.

Exhibit 2: Financial conditions have tightened significantly leading to lower homeowner affordability.

Source: First Republic Investment Management, Bloomberg. Data as of April 22, 2022