The Only Two Certainties for Second Half of 2022

The investing world seems highly uncertain these days. Investors are understandably having trouble balancing earnings, the Fed, fiscal policy, inflation, economic growth, disease control, and geo- and US politics.

However, there appear to be two relatively certain events central to our current portfolio positioning: 1) the Fed will continue to tighten monetary policy and 2) earnings will continue to decelerate.

If one had to construct a 2x2 matrix of potential market environments in which choices had to be made between the Fed tightening or easing and choices between earnings accelerating or decelerating, it is highly unlikely investors would choose the combination of Fed tightening and profits decelerating. That has historically been a less common but unfavorable combination for the equity markets, but it does seem to be the one which could confront investors during the second half of 2022.

An uncommon and not particularly good combination

Chart 1 shows changes in the Fed Funds rate and the US profits cycle. With the exception of the period directly after the Global Financial Crisis, there was a reasonably high correlation between the Fed Funds rate and the profits cycle, i.e., interest rates rose as profits accelerated and fell as profits decelerated. That historical relationship implied monetary policy was a good ballast to economic and profits growth.

There have been periods when the Fed raised rates despite a decelerating profits cycle (i.e., 1989 or 2005). However, if our forecast for profits growth is on the correct path and the Fed continues to hike interest rates, investors might be faced with this relatively rare combination.