6 January 2023


Equity Investors, Keep Your Powder Dry!

Last year has been gruesome for equity investors, especially those invested in US stocks and in the tech sector. The 19.4 percent annual decline in the Standard & Poor’s 500 index was the strongest since the global financial crisis.

The main reason for the rout is inflation, the bugbear of stock markets. Consumer prices have risen as much as 9 percent year-on-year in the second half of 2022. That’s levels not seen since the 1980s, when Paul Volker had no qualms fighting inflation of as much as 15 percent with a Fed funds target rate of as much as 20 percent and inflicting recession on the US.

But there is hope for equity investors. As the chart shows, there have been several instances in the past, when declining inflation rates in the US (green line), have sparked a rally in stock markets (blue line, here the SP500 index as an example), especially in 2022 / 2003 and after the global financial crisis.

So, there is upside for equities and it depends to a large extent on where inflation rates are heading. The story of 2022 was how fast inflation rose. The story of 2023 will be how fast it falls. While supply side disruptions and rising commodity prices significantly contributed to the increasing price level, the concern in the US is the tight labor market, which might add another round to the wage-price spiral.

Still, the surprisingly soft November CPI print — the core gauge decelerated to 0.2% month over month — adds to the case that disinflation is building in the US. Easing supply constraints, discounts to clear excess inventory, a downturn in interest-rate sensitive sectors and lower energy prices have aided the Federal Reserve’s inflation fight. Early evidence suggests December price gains are tracking at a similarly soft rate. By the late-January FOMC meeting, some Fed officials may conclude there’s enough “compelling” evidence to start talking about pausing rate hikes.

Fed funds futures already show the market expectation that the US central bank might even go further this year and lower its benchmark rate in its tightrope walk between fighting inflation and avoiding a recession.

And lower inflation rates as well as a lower Fed funds target rate could bode well for stock markets, as it did in the past.

Equity investors, keep your powder dry!