‘Leap Of Faith’: Summer Rally Has S&P At Goldman’s Year-End Target

US equities reached Goldman’s year-end target four months early.

As you can imagine, the bank’s clients are asking the same question everyone else is asking — namely, they’re curious if the rally is predicated on a legitimate supposition about a potential Fed pivot or if this summer’s rebound was merely a bear market rally now primed for “reaping,” as Bloomberg put it, in a colorful piece published late last week.

The bank’s David Kostin said a “key macro driver has been the willingness of fund managers to embrace the view that the Fed will pivot and the US economy will achieve a soft landing.” Over the weekend, I advanced a version of the soft landing thesis. I don’t know whether to believe it or not. It seems plausible in the near-term, but over the medium-term, there’s a risk it all dead ends in sticky inflation that’s two percentage points above target and a Fed that can’t justify a policy rate below neutral.

As it turns out, differentiating between the end of Fed hiking cycles and bear market rallies is difficult whether you’re analyzing index returns or internals. The same goes for performance around Fed pivots (as tipped by market pricing) and the actual end of rate hikes.

Goldman used fed funds futures pricing, defining a perceived Fed pivot as “the first time in at least a three-month window that the fed futures market implies less than a 12.5bps increase in the front-end rate within the subsequent six months.” That’s a reasonable metric. There were seven such episodes since 1995, compared to six “last hike” episodes.

The median three-month return for US equities following the Fed’s last hike was 9%. Over six months, it was 16%. Those figures for perceived Fed pivots are 7% and 13%, respectively.

As the figure on the left (above) shows, there was one lonely outlier since 1995 — one instance when a Fed pivot wasn’t followed by a stock rally. As Kostin wrote, “in 2000, the pivot in Fed policy did not boost the equity market going into a recession.”

That’s potentially problematic in 2022 because… well, because technically, the US is already in a downturn, even as virtually no one believes the NBER will retroactively declare Q1-Q2 2022 an official recession.

But even if the first half of 2022 wasn’t “really” a recession, the economy could succumb soon enough. Neel Kashkari reiterated last week that Fed hikes to control inflation may result in a recession, and that such an outcome is acceptable if it means corralling the hottest price growth in a generation. Thomas Barkin echoed the sentiment on Friday, during an event in Ocean City, Maryland. “There’s a path to getting inflation under control but a recession could happen in the process,” he said, adding that a “tremendous decline in activity” probably won’t be necessary. That’s not especially comforting. It has a “when you have to say it…”-type of vibe.

Officials have sought (unsuccessfully) to dispense with the notion that rate cuts are possible next year. Goldman’s point certainly wasn’t to suggest we’ve seen the last hike. The bank expects 50bps next month and 25bps hikes in November and December followed by a pause. The point, rather, was to analyze the equity market’s behavior in the context of historical Fed hiking cycles.

“Although the market is not pricing the final hike until February 2023, recent sector and factor performance have closely resembled the historical pattern around the actual end of Fed hiking cycles,” Kostin wrote, adding that “performance around bear market rallies and the end of Fed hiking cycles look similar, and ultimately the path of both inflation and growth will determine the market’s trajectory through year-end.”

The problem, again, is the risk of recession. And also the risk of sticky inflation, as discussed at some length in “A Sticky Situation.” Kostin tacitly (and perhaps inadvertently) underscored the notion that the runway for a soft landing is very narrow, both for the economy and equities.

“While the index, sectors and factors behave similarly [around bear market rallies and the end of Fed hiking cycles], the 2000 experience illustrates the risk that the market could decline even after hiking stops if the US economy enters a recession,” he said. “By contrast, if inflation surprises to the upside and requires the Fed to tighten more aggressively than our economists expect, we would expect equity valuations to compress as a result.”

Goldman puts the odds of a recession in the next 12 months at one in three. Sitting atop Kostin’s weekly was this title: “Leap of faith.” It appeared to be a description of the summer rally.