There is nothing to fear but the Fed itself

May 22, 2022

David Bailin

Chief Investment Officer and Head of Citi Global Wealth Investments

Steven Wieting

Chief Investment Strategist and Chief Economist

SUMMARY

A very fast-moving correction is gripping equity markets because the economy is slowing, and the US Federal Reserve is still taking its fastest and most aggressive rate stance in decades. But indiscriminate selling, rather than tactical reallocation, may cause markets to plunge further.

As the S&P 500 approaches bear market territory, investors are looking to the Fed to see if it can engineer a “soft landing.” But the very use of that phrase ignores its definition. To achieve a soft landing, the Fed would typically need to raise interest rates just enough to slow inflation in an overheated economy without causing a severe economic downturn. Therein lies the stock market’s anxiety. The economy is slowing and the Fed is still taking its fastest and most aggressive rate stance in decades.
We modified our ratios for our ROBUST, RESILIENT and RECESSION scenarios to 20%, 45% and 35% respectively this past week. The increase in the RECESSION scenario percentage is linked to market action as markets typically lead the economy, particularly when a strong direction is sustained. The loss of confidence and the actual loss of buying power can be self-reinforcing.
In our view, a recession is not the only way for the Fed to stabilize inflation. A policy of gradual rate increases and patience may achieve the same goal. We see evidence that demand will be satisfied through an ongoing supply recovery. US industrial production is finally catching up to the rapid growth of imports. Both are now rising faster than consumer demand, measured in real units.
We believe there is a 70% probability that we are at or near peak rates for 2022. Last month, the GIC raised long-duration US Treasuries to an overweight for the first time since yields bottomed in 2020. We believe the positive correlation between high quality bonds and equities will break down, as has been evident in recent days as the equity selloff intensified. In our view, long-term government bonds should soon take comfort in a slowing growth outlook, and (with a lag) decelerating inflation. In the five previous cases of significant joint stock/bond losses during the past 60 years, long-term US Treasury returns were positive in all five cases.
To illustrate Citi Global Wealth Investment's philosophy, we conducted a hypothetical analysis of investor behaviors during five market crises over the past 50 years. In one scenario, staying invested – or better yet, deploying cash sitting on the sidelines – may lead to outperformance versus a de-risking strategy.

CIO Strategy Bulletin (PDF 892.70 KB)

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