In the first half of this year, US stock markets suffered a drop not seen in over 50 years. The S&P 500 index on Thursday June 30 was down more than 20% from January, a decline not seen since 1970.
The S&P 1500 index, constructed by Bloomberg and comprising companies of different sizes, has seen more than $9 trillion in market value disappeared since January. With the exception of energy stocks, all sectors suffered declines in value. On Wednesday, June 29, Citi announced that it expects the S&P 500 to fall about another 11% by the end of the year.
Stock market declines also occurred in Europe and Asia. Europe’s Stoxx 600 index is down about 17% since January, while the MSCI index for Asia-Pacific markets is down 18% in US dollar value. The FTSE All World index, which includes stocks from advanced and emerging economies, also contracted, just over 20% so far this year. Figure 1 shows how generally poor global asset class performance has been in the first half of the year.
Figure 1: Overall performance of asset classes: a painful 1H22
The perceived risk of recession in the United States and Europe has been a major factor in this flight of investors from the stock markets. Although US labor market numbers in May still showed a high degree of warming, household consumer spending fell in the month, on top of numbers from previous months that were revised down. Consumer confidence indices have fallen. In housing, the unprecedented rise in mortgage interest rates since 2010 has reinforced this deterioration. A report by the Institute of Supply Management (ISM) published friday july 1stshowed signs of a sharp decline in the pace of manufacturing activity in June in the US economy.
In Europe, there is also a sharp deterioration in indicators of manufacturing activity and consumer confidence in the German economy. The European economy was already expected to feel the brunt of the supply and price shocks resulting from the war in Ukraine. In Asia, the impacts of China’s zero-COVID policy had also already led to a downward revision of growth forecasts for the year. The real change now matches earlier signs that, in fact, the US economy’s slowing growth has joined that of other advanced economies.
A key driver of equity investors’ pullback has been the perception that signs of a slowdown won’t reverse the trajectory of rising interest rates on both sides of the Atlantic – predicted for later this year in the euro zone – and the tightening of financial conditions. During the annual conference of European central bankers in Portugal on June 30, the governor of the American Federal Reserve (Fed), Jerome Powell, even mentioned “some pain” as a bitter remedy needed to bring inflation closer to the 2% average target.
As Chart 2 shows, financial conditions have tightened as government bond yields have risen globally, including in most emerging market economies, with the exception of China. These tight conditions are likely to get worse as central banks continue to move down this path.
Figure 2: Financial conditions have tightened as government bond yields have risen
In this context, the devaluation of equities is part of other elements of US monetary policy aimed at reducing inflation rates. In addition to “quantitative tightening”—the gradual reduction of the Fed’s balance sheet, with no replenishment of maturing portfolio assets starting this month —the negative “wealth effect” of declining equity values will help contain aggregate demand, which which is precisely the policy objective of the Fed.
This is a significant difference from other times in recent history of the relationship between Fed policies and asset markets. In 1987, after a nearly 30% drop in US stock prices, then-Fed Chairman Alan Greenspan cut interest rates in what became known as the “Greenspan put”: a kind of loss insurance, similar to a put option bought to protect against sudden losses in value, only in this case provided by the Fed and free for asset holders. In the years that followed, the expectation of bailouts via Fed monetary policies in response to asset devaluations came to be incorporated as a premium into asset values.
This was the case, for example, in 2018. But not this time. The commitment to reduce inflation by containing global demand now appears to be the priority.
Strictly speaking, the Fed can ignore the decline in equities while keeping an eye on credit markets, not least because there is a direct relationship between credit and the creation of bank money, and therefore implications for aggregate demand. and inflation. But the Fed cannot ignore the systemic risks of insolvency of financial intermediaries.
And how are prices behaving in credit markets? Risk spreads widened for both junk (CCC-rated) and investment grade bonds. In addition to the risks linked to the rise in interest rates, attention has now turned to the risks of credit and the disappearance of liquidity.
Judging by reports from credit rating agencies, US non-financial corporations took advantage of the facility opened by the Fed in March 2020 in the wake of the pandemic-triggered financial crisis to extend debt maturities. on favorable terms. The apparent magnitude of the rate hikes, regardless of their impact on corporate equity structures, provides comfort to the Fed in its pursuit of rate hikes. Furthermore, rates are still low in real terms when discounted by inflation rates expected this year and next year.
How far the Fed will go is an open question. It will depend on signs of inflation as interest rates rise. In a bad sign, the index that serves as the official benchmark, the personal consumption expenditure (PCE) price index, rose in May and reached a level 6.3% higher than a year ago. In the euro area, inflation in June reached a record 8.6%.
Long-term inflation expectations expressed in US 10-year inflation-protected Treasury bills are around 2.36% per year, remaining in the range between 1.5% and 2.5% which is the hallmark of the last twenty years. If inflation shows clear signs of slowing in the coming months, the Fed may miss the 3.5% to 3.75% range currently expected by the middle of next year. The problem is that, even knowing that there is a lag between interest rate decisions and their effects, the Fed cannot ignore what will happen to monthly inflation rates through the year next, even if it poses a risk for a soft landing of the economy.
Of course, significant negative surprises on the corporate finance side could also lead to a sort of “Powell put”. What seems more likely, however, is a combination of a global economic slowdown and a continued tightening of global financial conditions. Stock markets in advanced economies will continue to decline until the monetary and financial grip eases.
Otaviano Canuto, based in Washington, DC, is a Principal Investigator at Policy Center for the New South, lecturer in international affairs at the Elliott School of International Affairs – George Washington Universitynon-resident principal investigator at Brookings Institutionprofessor affiliated with UM6P, and principal at Center for Macroeconomics and Development. He is a former vice president and former executive director of the World Bank, former executive director of the International Monetary Fund and former vice president of the Inter-American Development Bank. He is also a former Deputy Minister of International Affairs at the Brazilian Ministry of Finance and a former Professor of Economics at the University of São Paulo and the University of Campinas, Brazil.