Equity markets have sold off on uncertainty around how quickly and how far the US Federal Reserve (Fed) will have to go to curb inflation in the US but Director of Research Matt Peron says once the outlook becomes clearer – which could take until the middle of 2022 – smoother sailing could return.

Key takeaways

• The Fed’s shift in posture on inflation and how aggressive it may need to be to combat it has contributed to significant volatility as market participants question how the economy will respond to rising rates.
• Strong company earnings remain a bright spot, something we expect to continue – unless rates move too far or too fast – and US companies may be near-term beneficiaries of the policy shift.
• While volatility will likely continue in the first half of 2022, we expect a smoother second half of the year as the Fed’s policy path becomes clearer.

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This week we had quite a bit of market volatility, primarily driven by the Fed and their change in posture around inflation and being more hawkish. But you add in also some geopolitical concerns as well as COVID concerns and it was a recipe for a correction in the market, which we saw in the first half of January.

So far we have not seen the impact of affordability or higher prices curbing demand, though that is one risk of a slowdown in the economy. Another is that the Fed will have to raise rates to slow down the economy, and that is really what the market is focused on. Given that the Fed has changed their posture and how they are thinking about inflation, they have signaled that they need to act faster and more aggressively. That has added a lot of uncertainty to the market in terms of how will the economy respond when they do raise rates and how much will they raise rates in the coming quarters.

Earnings have been quite strong for the market and we expect that to continue. Inflation actually boosts earnings in and of itself, so that higher inflation is actually good for corporate earnings.

While earnings are quite strong right now there is some question as to whether they will remain strong in the face of rising rates. We think they will. Up until a point. If rates go too far or too fast, that will start to impact economic activity, especially in the more rate-sensitive sectors of the market such as housing, mortgage applications and autos.

The real source of uncertainty is what will the earnings multiple be. What will the valuation of the market look like. And when rates are rising, typically, valuations will compress. Now, some sectors will be more impacted than others. And typically companies with near-term cash flows who are established and more mature will be more resilient in the face of rising rates, whereas earlier stage companies will sometimes be disproportionately impacted by rising rates in terms of their valuations.

Typically during periods of transition from accommodative monetary policy to tighter monetary policy, you will often see markets with more resilience and higher quality outperform. As a result, we think investors will gravitate toward the U.S. in the short term. But when the monetary policy path is clear and the market gets comfortable with that, there will be a catch-up in other developed markets and likely in emerging markets who typically do struggle during periods of monetary transition.

In our 2022 outlook, we expected near-term volatility and perhaps even a correction as the Fed got more hawkish in their policy stance. That has so far come to pass, but we don’t think it’s over yet. It will probably take up to six months for the market to get comfortable with the path of monetary policy in the coming quarters and years. However, once it does get comfortable with that, there are typically gains in the market for a number of years before the cycle ends. So as a result, we are much more constructive on the second half of 2022 than in the near term. We think there is smoother sailing as the market becomes more comfortable with and gets more clarity on how the Fed will proceed with rising rates.