Haemorrhage in Asset Markets
as markets display “irrational exuberance” on the upswing, they can display excessive pessimism on the downside.
The Fed, the markets and liquidity
What happens when you get carried away at a dinner or a party? You forget the second layer effects you’ll have in the morning. Up until this year, we have experienced a goldilocks environment within financial markets; rallying equity market, robust labour market and narrowing credit spreads. As we know, credit spreads tend to widen during economic recessions and indicate an increased risk of default as well as reduced liquidity in the market. I’ll dive in on the importance of this instrument in a later piece, I’m still digesting its properties.
Although we can say the Fed is to blame, which correctly they are, navigating monetary policy to avoid turbulence over the past two years has proved difficult amidst a global pandemic, war and supply chain issues.
As shown by the chart above equities are down almost 20%, putting stocks in bear market territory, bonds have had their worst run in decades and crypto, the long-sought hedge has exceeded losses with its tight correlation to stocks. Year to date we have destroyed 14% of the global market value totalling roughly $35 trillion. Yes, $35 trillion.
To emphasize this point take a look at the chart below, since 2018 analysts have calculated the correlation between the SPX and Fed balance sheet has been 0.92. To put it into scope, a correlation of 1.0 is a direct relationship par-to-par. A correlation of 0.92 means that for every $1 expansion in the Fed balance sheet the S&P 500 gained that same $1 amount.
The most concerning thing is the Fed has not started its balance sheet run-off yet and markets have fallen off the cliff. Investors are feeling the effects of liquidity tightening within the economy and there’s no place to hide. Things are set to get worse as the Fed battles inflation, now it must be said that a soft landing isn’t probable. There has to be a trade-off, you can’t reduce liquidity in the economy in attempts to lower inflation whilst maintaining a tight labour market. It’s evident that the tight labour market will be the sacrifice as corporations begin to adjust to policy events.