To Pivot or Not to Pivot

The Arthur Ravenel Jr. Bridge in Charleston SC by Dong (Dec.2022)

As far as bear markets in stocks go, 2022 is not all that noteworthy. Once we examine the broader settings, its uniqueness becomes evident.

To recap: the S&P 500 index ETF SPY was down 18.11%; NASDAQ ETF QQQ was off 32.94%; Vanguard Total Bond Index ETF BND fell 12.61%; Small cap stock ETF IWM dived 20.60% and emerging market stocks ETF VWO slumped 16%. According to Yale professor Robert Shiller, the combination of both stocks and bonds declining by over 10% has never occurred before 2022, with data going back to 1871.

Some say that the most dangerous words in finance are “this time is different.” How are we to summon our experiences and knowledge to foresee a future when events unfolding before us have no precedents? When uncertainties are high, bets should be reduced, and time horizon shortened.

In the newly released minutes for the December FOMC meeting, The Federal Reserve reiterated its intention to bring inflation down to its target rate of 2%. It explicitly stated that “no participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.” Such resolute hawkishness sounds ominous for risk assets. But markets are not convinced. For that, we do have history and it shows when the decisive moment arrives, the Federal Reserve always yields. Price action for the fed funds future reflects 40 basis points of interest rate cut in the second half of 2023.

This is the widely anticipated Fed pivot. The hope of the stock market in 2023 rests upon it.

Given the high level of national debt, the US government can’t afford prolonged periods of high interest rates. But with high inflation, the monetary authorities can not maintain low interest rates. The strategy for the Federal Reserve is to weaken the economy quickly, then it can pivot to an interest rate that maintains the solvency of the Federal Government. The pivot will happen. Timing, however, is uncertain.

The GDP Nowcast from the Atlanta Fed calls for fourth quarter growth of 3.8%. Given the lag effect of monetary policy, it is entirely possible that real GDP growth will remain in positive territory throughout 2023. In such a scenario, a Fed pivot may not happen at all. While the present economy remains strong, forward-looking indicators are clearly stressed. During a lengthy period of easy money, there are always significant economic players who become over-leveled. As the consequence of high interest rates gradually takes its toll, stress tends to give way to panic. When markets panic, it will force the Fed to pivot without accomplishing its stated goal of weakening the economy and labor market. Such a premature pivot may calm the market temporarily until inflation roars back once more. In an ideal scenario, the Fed stays resolute and only pivots until the labor market and economy gets decimated. The late pivot will do greater damage to financial assets in the short term. The subsequent recovery should also be more durable.

I do not know which scenario may play out. The astute investor must remember that for the Fed pivot to happen, a cataclysmic event must first ensue. When the pivot does happen, it’s still imperative to identify the circumstances.