Written by: Kevin McCreadie, CFA®, MBA | AGF
Why are equity markets falling again?
It’s pretty simple, really. Markets rallied earlier this summer on the idea that inflation had peaked and central banks no longer needed to aggressively raise rates. But that idea has been thoroughly dismissed over the past month, first by central bankers themselves – who pretty much all along have been telling investors that their fight against higher prices wasn’t over – and then, finally, once and for all, when higher-than-expected U.S. inflation figures for August came out last week.
In fact, if anything, the question now is whether the U.S. Federal Reserve and its ilk need to be even more aggressive going forward, not less. To that end, recent estimates show the Fed’s terminal rate (or point at which the Fed pivots to rate cuts) has increased to almost 4.5% from around 3.7% just a month ago, meaning investors can expect rates to rise in the U.S. by another 200 basis points from current levels.
But the sheer magnitude of future rate hikes may not be the biggest concern of investors. For instance, if it took a couple of years to reach 4.5%, consumers would have time to adjust their spending habits in a measured way that doesn’t necessarily act as a drain on overall economic activity. However, it could be a very different story if the Fed rachets up the pace of its current rate hikes and tries to reach its terminal rate in a matter of months. In that case, mortgage and loan payments are immediately much more expensive than they were before the increases and consumers are almost forced to make choices and reduce their overall spending.
So, it may be the pace of the rate hikes that are still to come – more than the magnitude of them – that investors should be worried about most. Plus, we still don’t know what effect the rate hikes already announced by the Fed this year will ultimately have on the U.S. economy. Largely, that’s because of a natural lag that often occurs between the time rate increases are announced and when their impact on economic growth starts to fully show up in the data. Take labour markets, for example. They appear healthier than ever based on the current unemployment rate of 3.7%, but underneath the surface, a slightly different story is starting to emerge, especially in economic sensitive sectors like construction where job losses are now on the rise.
Taken all together, investors are now dealing with a very different macro environment than they thought or hoped they would be just a few short weeks ago. And to be clear, this isn’t just a U.S.-centric story. The same conditions also apply in several other countries and regions of the world, including Europe, which may be in the most difficult spot of all. The European Central Bank is not only being forced to raise rates at an unprecedented clip to combat inflation levels that are among the highest in the world, but it’s having to do this at a time when Europe’s economy may already be in a recession and could slump even more this winter given the ongoing Ukraine War and escalating price of natural gas prices.
What should investors expect of markets over the next few weeks?
It probably goes without saying that markets will likely remain highly volatile through the end of the year and the possibility of another significant downswing from current levels can’t be ruled out – nor should the idea of a sizeable rally if the data lines up right over the next few months.
Perversely, bad news about the economy (i.e., weaker growth, rising unemployment) may end up being good news for equities if it forces the Fed and other central banks to rethink their current stance and markedly slow the pace of their rate hikes or stop them all together.
Granted, for this to happen, there likely needs to be good news on the inflation front as well. Indeed, the worst scenario for markets maybe one where inflation persists at current levels, while economic growth slows dramatically.
Either way, it’s unlikely that central banks ease up on rates hikes anytime soon. They’ll probably need at least a couple of months worth of statistics to work from before deciding on their next pivot. As such, investors should remain cautious over the near term and ready for more of the same choppiness that has defined markets so far this year.
Related: Debt & Why The Fed Is Trapped
The views expressed in this blog are those of the authors and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
The commentaries contained herein are provided as a general source of information based on information available as of August 31, 2022, and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.
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