Speaking with a number of market players over the past few weeks, there seems to be a broad consensus that 2022 will be more difficult than 2021, which almost makes me wonder if stocks will not rise again. by 20% next year, once again defying bearish expectations. But things are a little different than they were then a year ago.
To begin with, the Federal Reserve is beginning the process of reversing its ultra-accommodative monetary policy. This is not moving fast enough compared to the inflation that has kicked in, but it is done in an environment where markets are increasingly sensitive to the possibility of higher interest rates, due to the enormous leverage of the system and the amount of public debt contracted. during the last years.
The Fed has yet to raise rates, and likely won’t do so until March, but the yield curve has already flattened to 80 basis points, suggesting that we are moving closer and closer to a recession.
I’ve been through a few cycles of yield curve flattening and each comes with a series of silly analyzes. The first is the mechanics behind the measurements. The convention is to use the difference in yield between two- and ten-year US Treasuries, but there are some annoying purists who always come out of the woods and say you should really use the three-year or two-year Treasury bill rates. six months instead. two-year returns. Typically, it takes longer for the curve to reverse when bills are used as a benchmark, giving people hope that a recession is further away than they think.
The second is speculation that this time is different, and that perhaps this particular flattening of the yield curve, or even an inversion, will not lead to a recession. But the yield curve is the undisputed heavyweight champion of market indicators – a reversal always precedes a recession. It’s just a matter of timing. If the Fed stays on its current path – or accelerates – then it looks likely that the yield curve will reverse in early 2022, just when real rate hikes are expected to begin. Then the clock begins, as a recession can strike at any time over the next 18 months, depending on the relationship between yield curve reversals and economic contractions.
The question then becomes by how much will the stock market fall? Potentially a lot. Stocks weren’t particularly cheap before the pandemic, and there has been a lot of speculation and froth over the past 18 months or so. For example, a 20% drop, the technical definition of a bear market, would bring the S&P 500 index back to early 2021 only.
Investors should also consider the Fed’s reaction function. If the current high inflation rates don’t come down, the Fed could panic and raise rates too far, too fast, triggering some kind of crisis. The Fed has already erred in believing that the acceleration in inflation was transitory, and the risk that policymakers will make a second-kind mistake, by overreacting and plunging markets into chaos, does is not zero.
If that wasn’t enough, 2022 will bring the US midterm elections. Current polls suggest Democrats are heading for a big defeat in Congress, with Republicans taking control of the House. A lot can change by November, but it’s hard to see Democrats increasing their majority at this point. This has profound implications for fiscal policy. Huge Republican gains in the 1994 and 2010 midterm elections resulted in six years of relative austerity under Presidents Bill Clinton and Barack Obama. The result was a budget surplus at the end of Clinton’s second term. Fiscal spending was particularly low from 2010 to 2016, with the budget deficit falling from around 10% of GDP to around 2% of GDP. Republicans are by no means fiscal conservative, but they reliably are when in opposition.