Market volatility reflects higher interest rate outlook and US recession risk

It’s been a hairy few weeks for US equity markets.  The S&P 500 moved into “bear market” territory – 20% down from its peak – during Friday’s trading session but managed to avoid closing at those lows. The index is still down more than 18% year to date and will likely follow the Nasdaq composite into an official bear market at some point in the coming weeks.  The last time US equities went into a bear market was Q1 2020 at the start of the Covid-19 pandemic. That didn’t last long, however, as the Federal Reserve cut interest rates to almost zero and embarked on a massive quantitative easing cycle to support the economy, while the government put money in the pockets of consumers and businesses through various relief and stimulus measures. 

The Fed is unlikely to come to the market’s rescue this time around.  Indeed part of the reason for the recent sell-off in equities has been the re-pricing of interest rate expectations as the Fed has sounded increasingly hawkish in recent weeks.  At the start of the year, the market was pricing just three 25bp rate hikes, or 75bp in total, over the course of 2022.  We have already had 75bp basis points in rate hikes since March, and several Fed speakers have indicated they would like to see the federal Funds rate rise to at least the neutral level, estimated at 2.5%, before the end of this year, implying at least another 150bp in rate increases by December. The market is pricing a more aggressive 175bp in hikes over the rest of this year, which would take the upper limit of the Fed Funds rate to 2.75% in December from 0.25% in January. An aggressive reduction in the size of the Fed’s balance sheet would tighten financial conditions even further.

But higher borrowing costs are not the only factor driving equity prices lower; markets are becoming increasingly concerned about the likelihood of a recession in the US over the next eighteen months. The US economy shrank on a quarter-on-quarter basis in Q1 2022, although this was largely brushed off as due to technical factors –imports increased as port disruptions eased and inventories which firms had aggressively built up in Q4 2021 declined in Q1 2022. The US consumer was in a strong position, it was argued, and would continue to drive economic growth albeit at a slower pace, as the Fed raised borrowing costs.

There is plenty of data to support this view: the unemployment rate is at 3.6%, almost the pre-pandemic low, wage growth is strong, household balance sheets are in good shape and there are still excess savings that would allow consumers to maintain spending even as inflation erodes purchasing power.   

However, the quarterly earnings reports of large US retailers including Amazon, Walmart and Target, suggests that there are cracks under the surface with respect to the US consumer.  While headline spending growth remains solid, rising 0.9% m/m in April, consumers appear to be reducing spending on discretionary items such as homewares and clothes, and spending more on essential (and lower margin) items such as groceries, as higher food and energy prices affect spending decisions.  Moreover, credit card spending is on the rise according to some US banks. 

While a US recession does not appear to be anyone’s base case scenario at the moment, growth is expected to slow sharply by the end of this year as the Fed’s rate hikes start to bite. This is necessary for inflation to slow, which is the Fed’s main goal this year. Policy makers and most analysts have argued that there is a path to a “soft landing” where US growth slows enough to reduce inflationary pressures, without pushing the economy into a recession, but given that interest rates are a relatively blunt tool and can take months to feed through to the real economy, there is a non-negligible risk that the Fed moves too far too fast and the world’s largest economy starts to contract in 2023.

A version of this column appeared in The National on 24 May 2022.