A More Tolerable Phase of the Bear Market

The next phase of the bear market should be a bit more tolerable than the unforgiving version of the past year. Thinking once again about the phases of the bear market, per my interview with T. Rowe Price’s Sebastien Page, it looks like we are in the midst of transitioning from an Inflation Shock to a Growth Scare. For a market still heavily skewed toward technology companies, the effect of potentially peaking inflation on growth-stock valuations should give equities some legs until we find out just how much damage the Fed has done to the economy.

That doesn’t mean the inflation risk is gone. It’s still way too high, and the inflation crisis of the 1970s tells us that CPI can have big swings before peaking. But the Federal Reserve is laying the groundwork to slow their rate hikes from 75 to 50 basis points, which means the rate of change at which the economy is tightening, and valuations compressing, should slow. 

Of course, the key question is how much damage the rate hikes have already done. If you believe the yield curve, which is now firmly inverted, the damage is severe. Judging by that metric, a deeper version of whatever recession we may already be in is likely around the corner. Generally, I do believe the yield curve, but there are a few reasons to think the economy could be surprisingly resilient in the near-term.

Generally speaking, the data have been beating expectations. We saw ample evidence of consumer strength this past earnings season, most obvious in Walmart’s (WMT) report, which was a near-perfect microcosm of the big picture for American spenders: we don’t have the financial firepower from peak COVID stimulus, but we’re not totally broke and we’re willing to take on credit risk to avoid spoiling the holiday season.

The decline in the U.S. dollar suggests Treasury rates have further to fall, and the logic of potential macro outcomes fits: if the Fed turns dovish, bonds rally – and if the economy turns south, bonds rally. My Risk Radar turned green for bonds Tuesday because the only scenario in which rates spike right now is if Powell shocks by doing another 75 bps, or the next inflation print reverses higher. The unbreaking wishful attitude of traders the past two years tells us people will likely interpret any rally in Treasuries as a reason to speculate, even in the most moribund of assets. It’s a window of opportunity for bulls until the damage to the economy becomes painfully obvious.

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