The S&P 500 had just rallied 7.5% over the past week and screams of "the bottom is in" echoed across trading floors and phones went off the hook with clients wondering whether it was time to buy more. The memory of portfolio managers seems more like a goldfish's -- it is as short -- as they recall each 20% selloff in the past decade to be accompanied by Fed cuts and market bottoms. But this time is different.
It's different now not only because debt has never been as bloated as it is today, but inflation is still at abnormally uncomfortable levels of 8%-10% year-over-year. This is the one main difference vs. the selloffs in the past decade where the Fed always stepped in to support risk assets. This time it is cornered and unable to do anything other than hope the market finds its balance and achieves a soft landing as the Fed raises rates.
The U.S. and global economic data has been falling precipitously and we are in gross domestic product contraction mode already. Forecasts are calling for 0% growth for the second quarter. Recession is no longer an illusion: It is already here. The point of debate is how long and deep will it be. We all know that by the time it actually shows up in the data, the market will have already priced it in.
But now, the length of the recession all depends on how successfully the Fed manages to get inflation in control before the system collapses. After the recent batch of data, the market is now pricing in rate cuts for next year, which may seem positive eventually, but it does not mean the Fed is done raising rates. Bear markets are synonymous with nasty squeezes, as traders and technical indicators turn extremely bearish and bounce from oversold levels, the bounce being more aggressive the deeper we get in the bear market phase. This makes it an increasingly difficult landscape for both bulls and bears as they get pushed and pulled on the way up and down.
The second quarter has been a disastrous quarter for both equities and bonds, but according to Goldman Sachs, there is about $30 billion of pension rebalancing flows that are due to come to the market, which can help in supporting the market here as they window dress into quarter's end. With the market liquidity so thin, even the smallest of flows have the biggest of impact. But it is important to keep the bigger picture in mind. Global GDP is contracting and even entering recessionary levels after the excess liquidity that was pumped into the financial system during Covid. We are normalizing, the only problem is that the system is so levered that it is unable to handle even the slightest move up in rates. But the Fed has no choice as it is behind the curve and knows it. The sooner it raises, the more it will have to cut if and when an emergency does arrive. But it will not be able to anything till inflation has settled to around the 2%-3% level, at the least.
Over the past week, the dollar has fallen and bonds bounced, taking tech stocks higher as the Nasdaq is up 10% from its lows and nears the top end of its resistance range. But the bigger picture has not changed. We are still in an environment of higher yields, rates, and a Fed that is hellbent on reducing liquidity in the system. The same liquidity that had helped all risky assets reach to such great heights. One thing that may cause the Fed to rethink its strategy is if employment starts to fall as initial jobless claims start to pick up. We have already heard of tech companies laying off people, as demand slows and capacity needs to be cut. If this turns out into a much bigger move as the economy slows, this could make the Fed uncomfortable in raising rates. For now, their job is not done yet. Calling bottoms is a futile attempt as this is not an investment market, at least not for now.
