Below you can see Wells Fargo’s latest Fed balance sheet size projections.
Recently the Fed has:
👉 announced tapering (Autumn)
👉 begun tapering (Dec 2021)
👉 announced that they plan to speed up tapering vs. what they previously planned (from USD15bn/month to USD30bn/month) (announced after Dec FOMC meeting)
👉 announced that right after reaching net neutral monthly purchases (expected in March 2022 at this pace), the FOMC will start raising rates (currently 3-4 rates prices in for 2022)
👉 started a conversation on balance sheet run-off (“later in 2022” as Chair Powell has put it. Well, that’s quite a change from the rethoric we yet knew in Septemper 2021.
Ok, but what does it all actually mean? 🤔
👉 The Fed acknowledged that inflation is not as “transitory” as previously expected.
👉 They took 1st actual steps towards tightening monetary conditions…
👉 …at a pace potentially faster than most think (dependant on the CPI/PCE/PPI traction throughout 2022 of course)
Basically, the Fed has started sucking in liquidity from the market. Market conditions in money and bond/MBS markets will get much tougher this year. Fiscal issuance from the US government will face lower Fed demand (and it represents a big portion of total demand in Treasury auctions), natually leading to higher yields (this process is already under way). For equity investors it obviously means higher risk-free discounting rates, read lower acceptable valuations, especially for Growth stocks.
And what does history tell us?
The last time the markets faced a Fed balance sheet run-off was in 2018, when in the second half of the year the central bank decreased the size of its balance sheet from USD4,5tn to under USD4tn. As an effect, equity markets took a deep dive into correction territories (Nasdaq -24% and $SPX500 -20% top to bottom).
Start of this years look very 2018-alike with a few exceptions:
👉 Markets are now both nominally and on valuation basis substantially higher than in 2018;
👉 Inflation now is much higher than in 2018, thus the Fed’s moves to at least partially contain it may be faster and bigger than in 2018;
👉 Half of 2020 and whole 2021 were times of unprecedented low downside volatility, which consequently led to higher risk tolerance (represented for instance by equities ATHs, crypto market bonanza, records in IPOs an VC/PE deals worldwide). Currently cash buffers are low and leverage is generally high, especially among retail investors.
So how should investors position?
Basically…
👉 Avoid increased leverage;
👉 Avoid crowded trades in the Growth areas of the market and riskiest assets (like some cryptos possibly);
👉 diversify into more Value stocks…
👉 …and into asset classes that have zero or negative correlation to stocks (Treasuries: SHY, $TLT, etc. OR $GOLD);
👉 keep an appropriate cash buffer to use it for potential cheap purchases;
👉 hedge your equity exposure to avoid downside volatily (but this will also limit your upside of course!) – not suggested for less experienced investors.
My view: I think we will see more bumps this this year than in the last 18 months. Generally I stay constructive on equities selectively. Keeping my EY2022 $SPX500 tgt of 4900-5000pts, but intra-year I think we will see good buying opportunities, as some kind of corrections (deeper or more shallow dependant on Fed’s reaction to them) are inevitable – 1st one is already underway.
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Yours, GlobalAlphaS 😁
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