How The Fed Could Kill The Bull Market

interest rates

With stock prices falling, economic growth decelerating and corporate earnings showing less upward momentum, the prospect of further increases in interest rates has investors on edge.

These changes threaten not just to stall the bull market, but also to set off a bear market plunge. "All year, we have been most concerned with the shrinking liquidity conditions as the Fed and other central banks have been tightening monetary policy," the U.S. Equity Strategy team at Morgan Stanley writes in their most recent Weekly Warm-Up report.

Even more than hikes in the federal funds rate, Morgan Stanley is focusing on the reversal of quantitative easing by the Fed and other central banks around the world, which may have an even greater upward impact on interest rates. The report warns: "Global Central Bank balance sheets growth...has been plummeting and will go negative by January if the Fed, ECB and BOJ do not change course. Historically, whenever this has happened, we ended up with a financial crisis, a recession or both."

Significance For Investors

As the Morgan Stanley puts it, "the markets...have been quietly revolting all year. Now that these revolts have reached the shores of the U.S. and the large cap tech stocks, more people are paying attention. We don't think the revolts will stop until central banks pause or at least signal they are concerned." The report adds, "when looking at the broader market, it looks to us like this rolling bear is quickly turning into a cyclical bear...nearly half of all the stocks in the MSCI US Equity Index have now fallen at least 20% from their 52 week high." 

A rolling bear market, as defined by Morgan Stanley, is one in which different sectors take turns suffering declines. What they call a cyclical bear market is a more coordinated downdraft in stock prices that nonetheless is shorter in duration than a secular bear market.

Much of the blame, the report asserts, lies with monetary policy: "the Fed and other central banks have [been] tightening more than the market (and possibly the economy) can handle and earnings growth is destined to slow significantly next year." As a result, the report says that earnings projections for 2019 look too optimistic, and that the odds for "a full blown earnings recession next year...is looking more likely."

 "All year, we have been most concerned with the shrinking liquidity conditions as the Fed and other central banks have been tightening monetary policy...market liquidity [is] about as bad as we have seen in our careers." — Morgan Stanley

On the impact of falling liquidity, Morgan Stanley says, "we expect violent rallies along the way but with market liquidity about as bad as we have seen in our careers, trying to capture them will be difficult." The report also observes that the S&P 500 Index (SPX) as a whole, as well as most sectors within it, are now trading below their 200-day moving averages, a key bearish technical indicator. Moreover, it cites a recent collapse in market breadth as evidence that the recent market downturn "is more fundamentally driven than most market participants and commentators have acknowledged."

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Looking Ahead

Despite the overall bearish slant of Morgan Stanley's report, they state "to be clear, we believe the S&P 500 is in a secular bull market that began in 2011 and this year represents a cyclical bear within a secular bull...we think this cyclical bear is taking the course of a consolidation that will keep the S&P 500 in a wide range of 2400-3000 for up to two years." The S&P 500 opened trading on Oct. 30 at 2,640.68, or 10.0% above the bottom of that range and 13.6% below its top. Given the Fed's determination to continue with increases in the federal funds rate, and to unwind its massive balance sheet, currently valued at $4.2 trillion per the Fed, the squeeze that rising interest rates will place on the economy, corporate profits and equity valuations is unlikely to abate.

Source: https://www.investopedia.com/news/how-fed-could-kill-bull-market/

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