Certainties we see for the next 6-12 months: 1) the Fed will be tightening and 2) profits will be decelerating. We’ve pointed out before this combination of events is not typically a good one for equity markets, and we now have our lowest equity beta and highest cash levels in years.
Chart 1 shows the combination of the Fed tightening and profits decelerating has been the worst combination for equity returns of the four possible. The probability of negative returns is the highest under the relatively certain scenario we envision.
The real Fed Funds rate remains historically negative despite the Fed’s repeated rate increases (see Chart 2), which suggests the Fed could be raising rates for some time to get inflation under control. Historically, it has been difficult to corral inflation without a positive real Fed Funds rate.
Chart 2: Real Fed Funds Rate (Sep. 30, 1970 thru Sep 16, 2022)
Chart 3 shows the profits cycle for the S&P 500®. Profits are already starting to decelerate after the post-pandemic period of exceptionally strong earnings growth.