2022’s Early Market Test ‘Just The Start,’ One Bank Says

If you wanted to adopt a constructive view (and where’s the fun in that, right?), you might argue that from a big picture, 30,000-foot perspective, January suggested markets can handle what’s likely coming their way in 2022.

I emphasized “big picture” because below the surface, one can find the still-smoldering wreckage of various train wrecks. Crypto has rediscovered some of its joie de vivre, but it was a graveyard last month, when the stock swoon acted as a kind of coup de grâce for an “asset” class that was already down dramatically from 2021’s euphoric highs. The same could be said of the Cathie Wood complex and unprofitable tech. By now, you know the story: The so-called “de-frothing” that began around this time last year crescendoed in January. If you were overweight various manifestations of the “hyper-growth” theme, it wasn’t pretty.

But stepping back a bit, there’s nothing unusual (at all) about a 10% drawdown on the S&P. Corrections of more than 10% have occurred in 62% of all calendar years going back nearly a century. And while the surge in US real rates was indeed rapid (a two standard deviation event), it would be a stretch to describe the fallout as a proper “tantrum,” notwithstanding frequent factor fireworks. Even the combination of i) the largest single-day value destruction event in history, ii) a hawkish turn from the normally staid ECB and iii) the first back-to-back rate hikes from the BoE since 2004, wasn’t enough to force an outright capitulatory purge last week.

“Between lunchtime on Wednesday, January 24, and this past Wednesday, there was a distinct feeling of ‘we made it’,” Morgan Stanley’s Andrew Sheets said, in a note dated February 6. He went on to describe the mood that prevailed just prior to last Thursday’s dramatics,

Yes, inflation has surprised to the upside. Yes, key data were weak. Yes, central banks are pivoting more hawkishly. Yes, yields are rising. Yet, thanks to good earnings and fund inflows, global equities are only down 3%. Well done. It’s tempting to think that this is the end of the story: The test arrived early this year, and the markets passed.

I do think there’s some validity to that glass half-full take. I’ve mentioned this several times previous, but some corners of the market were so bombed-out by the end of last month that it was difficult to imagine much in the way of near-term downside given the proximity of the zero lower bound — and I don’t mean central bank policy rates.

I used the figure (below) last week, but I wanted to highlight it again. This isn’t a market that’s ignored risks for the past 12 months.

Sure, all crypto might eventually converge on its intrinsic value. And I guess you could argue that some of the cannabis names are penny stocks depending on which way the regulatory winds are blowing. Finally, I suppose Cathie’s Ark may eventually run aground, never to float again. But unless you think it’s all going to zero by spring, 60-80% down is about as egregious as losses get — something about “rock bottom” being a “solid foundation.”

With that in mind, I suppose one worry going forward is that even if “rock bottom” is in for some of the more speculative corners of the market, it still feels like a “real” index-level drawdown is long overdue. And, as Morgan’s Sheets tacitly suggested, the forthcoming unwind of G4 central bank balance sheets could be the catalyst.

“This is just the start of the game,” he wrote, in the paragraph immediately following the excerpted passage above. “A record amount of stimulus is about to be withdrawn from the global economy. It begins.”

“It” is a $2 trillion reversal. That’s how much Morgan Stanley’s economists expect G4 central bank balance sheets to shrink from May of this year to May of 2023. That, Sheets noted, is “four times the largest 12-month decline ever.” You might recall that the last experiment with QT didn’t end particularly well.

Over the longer haul, I’m wholly dubious of the notion that the Fed will succeed in shrinking the balance sheet anywhere near estimates of the minimum. For example, BofA used the balance sheet as a percentage of GDP and an estimate of what’s required to provide adequate currency in circulation and reserves to the banking system, to project a $4.7 trillion minimum.

The standing repo facility presumably rules out a repeat of the September 2019 funding squeeze, but that’s hardly the only constraint on the Fed’s capacity to turn the ship around.

“Today, the Fed could cut its balance sheet by roughly $4 trillion before reaching 20% of GDP or hitting the minimum quantity based upon growth of its liabilities [and] in the future, it seems likely the Fed can shrink its balance sheet by around $2.5 trillion before hitting either the 20% GDP or minimum liability threshold,” BofA said late last year, in an analytical exercise aimed at answering a hodgepodge of client questions about runoff. “We are skeptical economic and financial conditions will allow the Fed to normalize its balance sheet to such a degree,” the bank went on to muse.

That skepticism is warranted. The repo squeeze was a technical problem that resulted from a miscalculation. More importantly, the Fed had the capacity to control and fix it, which they subsequently did. What’s not so easy to control (or fix) is the global, cross-asset fallout from a deliberate tightening of the liquidity spigot at a time when backtracking is made more difficult by the persistence of inflation.

“One often hears that central banks provide markets with a backstop, or ‘put’, given their desire to avoid tighter financial conditions, but [they] now have to balance this concern against their core mandates,” Morgan’s Sheets said. “And regarding financial conditions, isn’t tightening them kind of the point?”