High inflation and a hawkish Federal Reserve have sparked turmoil in markets this year, and while some are confident stocks will rise again once the Fed pulls back on its rate hikes, many experts have warned that investors should not be waiting for the central bank to ride to the rescue.
That’s because the Fed is trying to pull off a difficult balancing act between lowering inflation and preventing a recession, raising interest rates a whopping 425 basis-points this year alone. Higher rates can lower inflation, but hiking too far risks overtightening the economy into a recession – and hiking too little risks stagflation, a scenario where inflation becomes entrenched alongside anemic economic growth.
Rates are now at their highest level since the 2008, and the Fed isn’t done hiking. Fed Chair Jerome Powell has reiterated his committement to bringing inflation down with tighter monetary policy.
With stagflation too big a risk, the central bank may have no choice but to press forward – and it won’t backtrack to buoy a sinking market in 2023, according to these top voices in the market.
Mohamed El Erian, Allianz chief economic advisor
The Fed has no choice but to keep its monetary policy restrictive, as out-of-control inflation poses the greater danger, according to Mohamed El-Erian.
El-Erian has been a loud critic of the Fed’s response to inflation this year, slamming central bankers for saying inflation was “transitory” in 2021. This year, prices climbed to a 41-year-high, prompting the Fed to issue a stream of aggressive, 75-basis-point rate hikes that now makes a recession “uncomfortably possible,” El-Erian said.
That’s the cost of the Fed being late to the game, and the central bank can’t back away from its monetary tightening now, El-Erian warned. That would risk a rebound in inflation and lead to inflation expectations getting entrenched in the economy — a “stagflation morass that would be much worse in every respect.”
Nouriel Roubini, Stern School of Business economics professor
Roubini, who earned the nickname “Dr. Doom” for his grim economic predictions, warned that stocks could fall 25% next year in a severe recession — and the Fed could be powerless to prevent it.
“The mother of all stagflationary debt crises can be postponed, not avoided,” Roubini said in an op-ed for Project Syndicate this month, sounding off on the dangers of a stagflationary debt crisis — a financial collapse that combines 1970s-style stagflation and the 2008 debt crisis.
He noted the Fed was still struggling to rein in inflation, and the past decade of ultra-low interest rates have fueled insane amounts of borrowing from “zombie” households and banks. That could mean debt and inflation troubles as interest rates continue to rise.
“With central banks forced to increase interest rates in an effort to restore price stability, zombies are experiencing sharp increases in their debt-servicing costs … Simply bailing out private and public agents with loose macro policies would pour more gasoline on the inflationary fire,” Roubini said, predicting the Fed wouldn’t have the policy tools to prevent a financial disaster from striking.
“Once the inflation genie gets out of the bottle — which is what will happen when central banks abandon the fight in the face of the looming economic and financial crash — nominal and real borrowing costs will surge,” he added.
BlackRock
Strategists at the world’s largest money manager warned of a recession unlike any other, and central banks aren’t going to loosen monetary policy just to keep stocks afloat.
“Central bankers won’t ride to the rescue when growth slows in this new regime, contrary to what investors have come to expect. They are deliberately causing recessions by overtightening policy to try to rein in inflation. That makes recession foretold,” strategists said in recent report.
“We don’t think equities are fully priced for recession,” the BlackRock strategists wrote. “Corporate earnings expectations have yet to fully reflect even a modest recession.”
Savita Subramanian, Bank of America chief stock strategist
While investors are hoping for the Fed to pivot to more dovish monetary policy, it’s unlikely given the persistent nature of inflation, according to Bank of America’s chief stock strategist Savita Subramanian.
“I don’t think that’s going to happen. I think we’re going to fail to see the Fed bail us out, the market reacts badly, and then we get a normal recovery, which is what I think we need,” Subramanian said in a recent interview with Bloomberg.
Other market commentators have warned that stock rallies riding on the hopes of a Fed pivot have proven to be fleeting this year, and are preventing the market from fully capitulating. Bank of America predicted a recession would ravage stocks in early 2023, causing the market to plunge 24%.
“I would get ready for a very volatile January. I think that the higher the market goes in December, the worse it’s going to be in January,” Subramanian added, urging investors to dip out of equities in the short-term.
Morgan Stanley
The Fed won’t pull out of its inflation fight to boost stocks until 2024, even when a recession spawns mid-next year, according to Morgan Stanley.
“The Fed’s concerns about inflation stickiness trump concerns about slowing growth and weakening labor markets, and the Fed waits for evidence of a sustained inflation decline,” strategists at the bank said in a recent note.
That wouldn’t be unprecedented, as the Fed has refused to bail out stocks before. Former-Fed Chair Paul Volcker, whom Powell is often compared to, refused to cut interest rates in the early 1980s despite a harsh recession in order to see a slowdown in core inflation.
In the interim, there could be major headwinds ahead for the market. Mike Wilson, Morgan Stanley’s top stock strategist, warned an earnings recession would hit the market early next year, causing the S&P 500 to drop 20%.
