If Moody’s Analytics economist Mark Zandi is right, there’s a sizable stock market drawdown up ahead – and we can blame the U.S. Federal Reserve for it.
This is ironic as the Fed is largely responsible for propping up the market in the first place. For the past decade, the central bank has effectively served as the Plunge Protection Team.
Even when the S&P 500 plunged 34% last year due to the Covid-19 pandemic, the Fed pumped so much liquidity into the banking system that the S&P recovered within months instead of years, and actually finished 2020 up 16%.
That rally has persisted into 2021, but the conversation has changed this year from Covid-19 to inflation – something that Crush the Street has been warning investors about repeatedly.
And here we are: the Fed told you that it would let inflation rate “run hot,” and the U.S. annual inflation rate recently hit 5%, showing that dollar devaluation can rear its head suddenly and catastrophically after years of calm.
As a result, everybody knows that the Federal Reserve will have to raise government bond yields – even if Fed Chairman Jerome Powell wants to pretend otherwise.
U.S. 10-Year Treasury yield (in percentage points). Courtesy: CNBC
Wells Fargo Securities’ Michael Schumacher expects the benchmark 10-year Treasury Note rate to end the year as high as 2.20%.
Schumacher pinpoints inflation as the cause: “Core PCE which the Fed likes to look at is above 3% for the next year. It’s an amazing number. We have not seen inflation like that in the U.S. on a sustained basis for a very long time.”
So, after years of rampant money printing, the Fed will have to hike interest rates and that’s what the stock market fears more than anything, including pandemics.
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To his credit, Mark Zandi has been sounding the alarm bell on inflation for a while. In March, he asserted that inflation was “dead ahead” and that investors weren’t fully grasping the risks.
Zandi was 100% right about that, and now, he’s bracing for the problem to go from bad to worse – and hinting that this will be fully engineered by the central bank.
“Inflation is going to be higher than it was pre-pandemic,” he said. “The Fed has been struggling for at least a quarter of a century to get inflation up, and I think they’ll be able to get that.”
S&P 500 in late 2018. Courtesy: Yahoo Finance
To get an idea of how skittish Wall Street is, just go back to late 2018, when the 10-year Treasury yield touched 3% and the stock market immediately entered into a correction.
Zandi, therefore, is trying to prepare investors for a stock market pullback of 10% to 20%. Moreover, he Zandi believes that a quick recovery won’t be in the cards, particularly because the market is richly valued. So, he estimates that it could take a year to return to break-even.
Last week, when the Dow Jones Industrial Average had its worst week since October, investors got an inkling of what a real pullback would look like.
Billions of dollars of wealth could be destroyed – and there won’t necessarily be a backstop to the drawdown as stock valuations are sky-high.
And as they say, the bigger they are, the harder they fall.
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