Notwithstanding wild post-earnings crashes for a trio of large-cap growth favorites culminating in Facebook’s historic, $250 billion one-day meltdown, US equities have managed a decent rebound from January’s correction.
But there’s an implicit cap on gains.
The concept isn’t difficult to grasp. It’s captured in what, by now, is a familiar visual to regular readers. The figure (below) shows Goldman’s widely-referenced US financial conditions index, plotted with a version of the gauge that excludes equities’ contribution to the post-pandemic easing impulse.
It’s all about the stocks! Imagine that.
Clearly, the Fed doesn’t want to engineer a genuine stock market collapse. Rather, policymakers might see it as constructive if some of the proverbial “froth” comes out, and equities de-rate a bit, thereby tightening financial conditions in a way that doesn’t risk spilling over onto Main Street.
An outright crash, by contrast, is undesirable for (at least) two reasons.
- If stocks fall so much that financial conditions tighten rapidly, the Committee could feel constrained in their capacity to deliver more tightening in a timely manner to fight inflation
- Although a direct link between Wall Street and Main Street “proper” (where that means lower- and middle-income families) may be nonexistent, a simple ratio of US private sector financial assets to GDP suggests “Main Street” (where that just means the public) is more levered to Wall Street than ever. In that sense, “the quickest route to recession is a Wall Street crash,” as BofA’s Michael Hartnett put it late last month
The flipside to the above is that the Fed doesn’t want a runaway stock rally, either. If a controlled de-rating is desirable, an uncontrolled re-rating is undesirable, given the easing impact it would exert on financial conditions which, even after last month’s equity correction and attendant 50bps surge in 10-year real rates, were still looser than they were in March of 2021.
So, coming quickly full circle (and longtime readers will applaud me for this exceedingly rare nod to the virtues of brevity), the ceiling for equities is the point beyond which the Fed views additional gains as pushing financial conditions looser in counterproductive fashion vis-à-vis their intention to tighten policy.
This is why Nomura’s Charlie McElligott thinks there may be a speed limit for any stock melt-up.
“Looking ahead, I continue to message that there’s an overhead ‘lid’ on equities, where the Fed is effectively shorting Calls / upside because anytime [stocks] rally substantially higher, US financial conditions ease,” he said Friday. “And that’s exactly when we have to anticipate [Fed officials] to ‘up’ their hawkish messaging.”
I wonder how the Fed can limit the upside besides sounding hawkish. Perhaps by keeping the cards close to their chest they inject enough volatility that maintaining a given Sharpe ratio requires reducing the equities allocation permanently.
This is a good topic. The real world is messy- much more than we like to admit. In a nation that’s going tribal, it’s not necessarily clear what your tribe stands for. Example; what to do about Russia or China. So maybe the Fed is no longer clear who they take orders from. Who will mind the minders? Four years under King Ludwig the Mad have made every option more painful. As ever, where you stand depends upon where you sit.
The overhead lid on the stock market is based on the Fed mandates for employment and inflation. The lid is really where real interest rates need to go. Since the global financial crisis the economy has been on autopilot with the Fed making adjustments as they can with monetary policy. One of the Biden administration’s singular success stories is passing robust fiscal stimulus at the beginning of his term. This will enable the Fed to lift off zero and with any luck stay there. Based on what I can glean, lots of growth has been pulled forward with fiscal and monetary stimulus. The real question is whether the economy can catch some long term sustainable growth or whether the fiscal and monetary stimulus fade is going to make growth abate almost completely over time. Not much more is going to be passed soon on the fiscal side- although a smaller package at some point seems likely. We know that monetary stimulus is going to be withdrawn. So the big question is what is next? My base case is slowing growth starting in the second half of this year- inflation is likely to fall as well (how much?). Plus we do not know the path of covid- it is more important than most care to admit.
During the Tech Bust in 2000/01 there were the most ferocious rallies I’ve ever seen. If memory serves, NDX was up +7% one day. With modern markets, we could / should see even more ferocious counter-trend rallies in modern bear markets.
H-Man, yes, brief but succinct. I am going with ME and the flow. Everyone is jumpy. And expectations on a 50 bps hike jumped from single digits to the high 30″s. There appears to be no safe passage.