28 May 2022
Markets often have a “win-win” relationship with economic news: strong economic data signal healthy fundamentals, while weaker data encourage greater monetary policy support (or the Fed put) and indirectly lift equity markets. However, bad economic news today may truly register as bad news for the markets. Persistent inflation, geopolitical concerns, and risk-off sentiment have all weighed on equity markets. Importantly, the Federal Reserve (Fed) now prioritizes moderating inflation over supporting growth, potentially shifting the relationship between asset prices and the Fed.
Question: “Would this FOMC have the courage to endure recessions to bring inflation down if that were the only way necessary?”
Answer: “… We’re absolutely prepared to do that. It—wouldn’t hesitate if that’s what it takes.”
– Steve Matthews from Bloomberg News, Jerome Powell during his May 4, 2022 Press Conference
Currently, the US economy faces constrained supply and still-elevated demand in both goods and services. The path to moderating inflation is likely to require either a boost to supply or a reduction in demand. Still, the Fed lacks the ability to directly address supply chain disruptions or compel labor force participation. Instead, the Fed looks to address inflation by tightening financial conditions and moderating demand. Tighter financial conditions would limit household consumption and reduce business investment, thereby allowing supply and demand to partially rebalance and alleviate existing price pressures (Exhibit 1).
EXHIBIT 1: US FINANCIAL CONDITIONS HAVE TIGHTENED MATERIALLY IN THE PAST TWO YEARS
Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. As of May 20, 2022.
The Fed tightens financial conditions through five primary mechanisms: 1) higher long-term interest rates, 2) higher short-term interest rates, 3) wider credit spreads, 4) lower equity prices, and 5) a stronger trade-weighted USD. The primary lever the Fed can directly pull is short-term interest rates, or the Federal Funds rate. However, market perception of a higher Fed Funds rate can indirectly influence other mechanisms. For example, since the beginning of the year, market pricing of additional rate hikes has led the 10-Year Treasury yield to increase 127 bps from 1.51% at the end of 2021 to ~2.78%. This rate hike repricing has subsequently moved credit spreads wider and equity prices lower. Expected policy tightening has also led the US dollar to appreciate against a basket of currencies to the 96th percentile over the past two decades. In aggregate, all of these movements have contributed to a 220 bp increase in US financial conditions (Exhibit 2).
EXHIBIT 2: FINANCIAL MARKET MOVEMENTS CAN BE INSTRUMENTAL TO TIGHTENING FINANCIAL CONDITIONS
Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. As of May 20, 2022.
In our view, the Fed put has likely expired. With the ultimate goal of lowering inflation, we expect the Fed to continue tightening financial conditions. This path forward may drive the Fed Funds rates higher, inflate long-term rates, moderately widen credit spreads, strengthen the US dollar, and ultimately, keep equity volatility elevated. In essence, we believe that the Fed today is more comfortable with equity market volatility than it was in the past, and market participants have moved from buying dips to finding caution in rallies.
That said, favorable fundamentals still support a modestly pro-risk posture. Overall, the 1Q earnings season has exceeded consensus expectations as US companies have generally demonstrated adeptness at passing on the effects of inflation and defending profit margins.
Still, we expect additional equity market volatility as investors await clarity on macro uncertainties. Allocations to fixed income and alternatives may reflect reasonable solutions to potentially capture additional yield and reduce risk alongside equity holdings. After all, markets are now transitioning from TINA to TARA: There are Reasonable Alternatives.
Disclosures
Notes
“Fed” refers to the Federal Reserve.
“Fed Put” refers to idea that in the Federal Reserve’s goal to support employment and growth through expansionary monetary policy would also indirectly act as a form of insurance against asset price declines, it would also support asset prices indirectly. In other words, the Fed would step in to support financial markets if they faltered.
Quotes for Jerome Powell and Steve Matthews are taken from the Federal Reserve’s “Transcript of Chair Powell’s Press Conference” from May 4, 2022.
The Goldman Sachs US Financial Conditions Index attempts to gauge the overall looseness or tightness of US financial conditions.
“Federal funds rate” refers to the interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis.
“Bps” refers to basis points, which are units that represent one-hundredth of a percent.
“YTD” refers to year-to-date.
“TINA” refers to “there is no alternatives,” a phrase indicating preference for equities.
Glossary and Risk Considerations
Equity securities are more volatile than fixed income securities and subject to greater risks. Small and mid-sized company stocks involve greater risks than those customarily associated with larger companies.
Investments in fixed-income securities are subject to credit and interest rate risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond's price. Credit risk is the risk that an issuer will default on payments of interest and principal.
Although Treasuries are considered free from credit risk, they are subject to interest rate risk, which may cause the underlying value of the security to fluctuate.
Investors should also consider some of the potential risks of alternative investments: Alternative Strategies. Alternative strategies often engage in leverage and other investment practices that are speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the entire amount that is invested. Manager experience. Manager risk includes those that exist within a manager’s organization, investment process or supporting systems and infrastructure. There is also a potential for fund-level risks that arise from the way in which a manager constructs and manages the fund. Leverage. Leverage increases a fund’s sensitivity to market movements. Funds that use leverage can be expected to be more “volatile” than other funds that do not use leverage. This means if the investments a fund buys decrease in market value, the value of the fund’s shares will decrease by even more. Counterparty risk. Alternative strategies often make significant use of over-the-counter (OTC) derivatives and therefore are subject to the risk that counterparties will not perform their obligations under such contracts. Liquidity risk. Alternative strategies may make investments that are illiquid or that may become less liquid in response to market developments. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. Valuation risk. There is risk that the values used by alternative strategies to price investments may be different from those used by other investors to price the same investments. The above are not an exhaustive list of potential risks. There may be additional risks that should be considered before any investment decision.
The above are not an exhaustive list of potential risks. There may be additional risks that should be considered before any investment decision.
General Disclosures
This material is provided for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
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Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this document and are subject to change without notice. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client. Actual data will vary and may not be reflected here. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only. The opinions expressed in this paper are those of the authors, and not necessarily of Goldman Sachs Asset Management. The investments and returns discussed in this paper do not represent any Goldman Sachs product. This paper makes no implied or express recommendations concerning how a client's account should be managed and is not intended to be used as a general guide to investing or as a source of any specific investment recommendations.
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Date of first use: May 26, 2022.