The risk of falling down

Fed minutes indicated an unanimous readiness by officials to speed up tapering and rate hikes due to high inflation and low unemployment. This triggered revisions of the 2022 economic projections, based on the sooner than expected end of large-scale asset purchases, four (instead of three) rate increases and the beginning of balance-sheet contraction. All these measures will decrease liquidity and put pressure on stock market valuations. The market expects the first interest rates to hike as soon as March (90% probability).

The economy remains strong and a total increase in interest rates of around 1% (four hikes by 0.25%) should not be too difficult to absorb. Earnings season starts at the end of this week. Most sectors are likely to see good results due to the increased demand and the low base effect from the previous year.

Inflation increased by 7% in December (up from the 6.8% in November), the largest jump since June 1982. Details of the CPI report have shown no signs that inflation is moderating. Both bond and stock markets barely reacted to this huge number indicating that high inflation and its implications are already priced in.

According to Mohamed A. El-Erian: "it is virtually impossible to answer with a high degree of confidence two key questions: How will the economy respond to the triple removal of monetary accommodation, and to what degree will financial conditions tighten?" Would the four interest rate hikes at some point result in a major increase in bond yields and correction of equities? Or will the strong economy carry on without noticing that the Fed removed the training wheels from its bike?

We believe that liquidity plays a very important role in valuations of the equity markets. A liquidity spasm is likely to bring significant volatility and downward pressure on the overpriced segments of the equity markets through the 1Q22.

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Light at the end of the tunnel

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