S&P Could Fall 40% In ‘Severe Hawkish’ Scenario

If we assume the likes of Bill Dudley, Larry Summers and Olivier Blanchard are correct to suggest the Fed will ultimately be compelled to engineer a meaningful increase in the US unemployment rate in order to bring inflation back to target, that raises at least two questions, and it doesn’t much matter the order in which they’re addressed.

The most obvious question for Main Street is how high the unemployment rate might “need” to go. For Wall Street, the question is what the asset price implications are from a Fed that endeavors to push the jobless rate up to levels consistent with some of the more hawkish calls emanating from economists and former officials.

As to the first question, Goldman’s Dominic Wilson and Vickie Chang constructed a “moderate” scenario in which unemployment rises to 5% and a “severe” outcome in which the jobless rate is 6%. “Using an Okun’s Law coefficient of two… this translates into GDP growth outcomes that are either 200bps or 400bps below our own forecasts on a one-year basis,” they wrote. They relied on a rule of thumb that says 100bps of FCI tightening is worth 100bps of GDP drag over a year, which means the Fed would need to engineer 200bps or 400bps of FCI tightening in the two scenarios, respectively.

Of course, economic downturns — and particularly severe recessions — do their own work. “Negative momentum,” as Goldman put it, would likely take some of the onus off policymakers. To account for that, Wilson and Chang assumed 150bps would ultimately be need in the “moderate” scenario and 300bps in the “severe” case.

As noted briefly here on Friday morning, the more benign scenario entails an additional 90bps increase in five-year US yields and another 4% rise in the dollar versus the bank’s own forecast, while the “severe” scenario would see five-year yields rise 180bps and the dollar a further 8%.

What about equities? Well, in the moderately hawkish scenario, Goldman’s approach “predicts that the S&P 500 would need to fall a little less than 15%,” while the “more severe version” predicts a 27% decline for the US benchmark, equivalent to SPX <3400 and 2900, respectively.

Those prospective outcomes, should they occur, wouldn’t count as singularly anomalous. The figure (above) gives you some context.

“The cumulative equity market declines from the highs this year of ~30% and ~40% implied by the two simple versions of this scenario would be large but firmly in the range of past experiences,” Wilson and Chang went on to remark.

Of course, all of this is extremely indeterminate, something Goldman readily conceded, calling the analysis “highly stylized” with “uncertainties at every step.” I should emphasize that this is not any sort of update to the bank’s house call. As far as I can tell, David Kostin wasn’t involved with the piece.

The point, rather, was simply to take a quick look at potential outcomes based on rough estimates for asset prices in the context of prospective increases in US unemployment under more onerous labor market conditions.

All caveats aside, Wilson and Chang said “the basic story is clear.” “If only a severe recession — and a sharper Fed response to deliver it — will tame inflation, it is likely that the downside to both equities and government bonds could still be substantial, even after the damage that we have already seen.”


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4 thoughts on “S&P Could Fall 40% In ‘Severe Hawkish’ Scenario

  1. At that point maybe some of the peanut gallery calling for rapid tightening with high terminal rate might think about the cure being worse than the disease….

    1. Riddle me this RIA: Who wins when the Fed raises interest rates to remedy inflation caused by worker shortages, higher worker wages, supply line problems, tariffs on Chinesium, a war in Europe and predatory fuel prices? Seriously, who comes out of this a winner?

      1. When the pie shrinks, it’s not about who wins, but about how to lose the least.

        Inflation tells us there are too few goods available for what we can currently demand. Market dynamics here force a slowdown in real consumption (e.g barrels of oil instead of market value of oil consumed), regardless of what the Fed does.

        Our only choice is to shallow out a prolonged recession or to let rampant inflation collapse onto itself when misery destroys our trust in our ability to exchange goods and services.

        Take your pick. I hope the Fed manages to get us the prolonged recession instead of an uncontrolled depression.

  2. Frankly, IB, you do not seem to me to be bereft, intellectually. My thinking the Fed and markets falls much more in line with you and Heisenberg.

    If we were NOT impacted by the deepening financial and political troubles around the world, I would feel a greater sense of safety in regard to US markets. But the wildcards at play today in our world are too great in number to overlook.

    Globalization, and the inexpensive production of American goods, is going away. That’s just one of the thorns poking at the American economy. There’s also a significant war in Europe that is teed up to escalate, if only because the Russians are losing and will want to save face. We’ll be damn lucky if they remove Putin from power. But I doubt that will happen because Putin is well practiced in insulating himself from all internal threats. There is a reason that people surrounding Putin are dying almost every day.

    Getting back to the war, Ukrainian military services will continue to humiliate the Russian army. If Putin retains power, the ineffectiveness of his army, which is proven by Russian losses, will not help him. As a result, it’s possible – maybe even inevitable – that Putin and the Russians, out of a sick desire to express their power and dominance, will use tactical nuclear weapons as a tool to discourage and intimidate the Ukrainians and beat them into submission. If that happens, the United States and NATO will be obliged to enter the conflict.

    War is certainly unpredictable. If any of these events happens, our markets will only dive deeper. I’m hoping and praying that Putin will be removed from power so cooler heads might have at least a chance to prevail. The highly successful Ukrainian counteroffensive, which is still in progress, is regrouping and evolving to its next phase. At the same time Russian soldiers are exhausted and don’t even know why they’re in Ukraine.

    The abundance of words I hear and images I see from Russia are expressing a desire for violence and vengeance. But they’re on a path to continuing loss. Other than nuclear, they don’t really have many cards to play in Ukraine.

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