In 2021, the stock market (as measured by the S&P 500) was up by 28.70%, but just six weeks into 2022, it is now down by 6%. What has changed? The economic data being reported so far this year is expected to force the Federal Reserve to raise interest rates and reduce the size of its bond buying program in an effort to reduce inflation.
To support the economy throughout the COVID-19 pandemic, the Federal Reserve kept interest rates low and flooded the economy with cash by buying bonds. The strategy worked; the economy recovered, and in turn the stock market boomed. The chart below depicts the size of the Federal Reserve’s balance sheet (blue line) versus the stock market (green line).
The Federal Reserve’s actions are a direct response to the bustling economic growth we have experienced. The stock market is always trying to price in the future. The fear is if the Federal Reserve’s actions fueled the surge in stock market value for all types of speculative assets (growth stocks, SPACs, cryptocurrencies), then withdrawing their support could spell trouble for those same speculative assets. The last time the Federal Reserve tried reducing their balance sheet was 2018, which was also the last year the market was down (-4%). 2018 was a volatile year for stocks, with a 20% decline starting in October 2018 that lasted until Christmas Eve 2018, when the Federal Reserve announced it would not raise rates any further.
Every year produces a different outcome, so we don’t expect 2022 to be 2018 all over again. What is uncertain is whether the Federal Reserve will be able to tame inflation levels without pushing the economy into recession. Without the support of the Federal Reserve, we expect the stock market to be more volatile than it has been the last few years. As always, we will be monitoring the entire economic landscape for both risks and opportunities.
If you have any questions, please do not hesitate to contact your financial advisor.
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