Ending QE: Another Challenge for Equity Markets

With the Fed ending its POMO operations yesterday (March 9th) following a nearly 5tr USD increase in assets since the beginning of Covid, investors have remained skeptical if the equity market will be able to reach new highs in the medium term. The deterioration in the Russia/Ukraine conflict has left risky assets vulnerable since the start of the year, and the surge in inflation combined with a expected significant deceleration in the economic activity have increased investors’ cautiousness for 2022.

The chart below shows the strong relationship between SP500 and the Fed assets since the beginning of Covid. With the Fed balance sheet pausing at 9tr USD, could we see new all-time highs in US equities in 2022?

Source: Bloomberg

Recession Risks Are Surging Globally

In addition to the consumer sentiment indicators, which have remained at ‘depressed levels’ amid Covid uncertainty in 2021 and the surge in inflation, the market uncertainty coming from the Russia/Ukraine conflict has increased the odds of a recession in 2022, particularly in Europe.

As war in Ukraine will lead to another inflationary shock, central banks will be ‘forced’ to tighten aggressively to tame inflation, which is approaching 10% in many EM and DM economies. As a result, the aggressive tightening response from central banks is very likely to accelerate the economic slowdown in the coming months.

Periods of surging ST rates have historically been followed by a significant deceleration in the economic activity. The chart below shows that the 2-year change in the 2-year US yield has strongly led the business cycle by 2 years in the past four decades. In the EM world, the impact is even faster with sharp increase in ST rates leading to economic slowdown in the next 6 months.

As opposed to the previous recessions in the past 30 years, governments and central banks will have limited ‘power’ this time as further stimulus and aggressive liquidity injections will lead to even higher inflation going forward.

Are we going to finally experience the ‘big bear’ equity market that a lot of participants have been waiting for in the past cycle?

Source: Reuters