‘No hiding place?’ Why stagflation fears are putting stocks on the brink of a bear market

‘No hiding place?’  Why stagflation fears are putting stocks on the brink of a bear market

It will take more than Friday’s big rebound to calm fears of a bear market in stocks, as uncertainty about the Federal Reserve’s ability to rein in inflation without weakening the economy has fueled fears of a bear market Fueling stagflation – a harmful combination of slow economic growth and persistent inflation.

Stagflation is “a terrible environment” for investors that usually causes stocks and bonds to fall in value simultaneously and wreaks havoc with traditional portfolios that are split 60% stocks and 40% bonds, said Nancy Davis, Founder of Quadratic Capital Management.

That was already the case in 2022. Bond markets have lost ground as government bond yields have moved inversely with prices in response to inflation, which is at its highest in more than forty years, coupled with expectations of aggressive monetary tightening by the Fed skyrocketed. Since the S&P 500 index’s record close on Jan. 3 of this year, stocks have been on a downtrend that has kept the large-cap benchmark on the verge of officially entering the bear market.

The iShares Core US Aggregate Bond ETF AGG,
-0.43%
down more than 10% year-to-date through Friday. It tracks the Bloomberg US Aggregate Bond Index, which includes government bonds, corporate bonds, munis, mortgage-backed securities, and asset-backed securities. The S&P 500 SPX,
+2.39%
fell by 15.6% over the same period.

The situation leaves “virtually nothing to hide,” analysts at Montreal-based PGM Global wrote in a note last week.

“Not only do long-dated government bonds and investment-grade bonds move almost exactly the same, but sell-offs in long-dated government bonds more often coincide with declines in the S&P 500,” they said.

Investors seeking comfort were disappointed on Wednesday. April’s much-anticipated US CPI showed that the annual pace of inflation had slowed to 8.3% from a more than four-decade high peak of 8.5% in March, but economists had been hoping for a more pronounced slowdown and the Core value sought, which is out Volatile food and energy prices posted an unexpected monthly rise.

This underscores fears of stagflation.

And Federal Reserve Chair Jerome Powell warned in a radio interview on Thursday that policymakers’ ability to fight inflation while avoiding a “hard landing” for the economy is not certain.

“The question of whether or not we can pull off a soft landing may actually depend on factors that are beyond our control,” Powell said.

Davis is also a portfolio manager of the Quadratic Interest Rate Volatility and Inflation Hedge Exchange-Traded Fund IVOL,
+0.69%,
with assets of approximately $1.65 billion intended to serve as a hedge against rising volatility in fixed income securities. The fund holds inflation-linked securities and is exposed to the spread between short and long-term interest rates, she said.

The rates market is currently “very complacent,” she said in a phone interview, signaling an expectation that Fed rate hikes “will create a disinflationary environment” when tightening is unlikely to do anything to solve the supply-side problems the economy is in the wake of plagued by the corona pandemic.

Meanwhile, analysts and traders debated whether Friday’s rebound in the stock market heralded the start of a bottoming process or was simply a rebound from oversold conditions. There was great skepticism about a floor.

“After a week of strong selling but with marginal inflationary pressures easing, and the Fed still appears locked in for a 50 basis point hike on each of the next two [rate-setting] Meetings, the market was poised for a strong rally endemic to bear market rallies,” said Quincy Krosby, chief equity strategist at LPL Financial.

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“Friday’s rebound managed to almost halve this week’s losses, but despite the massive upside volume, overall volume has been underperforming and more is needed to believe that even minor lows are imminent,” said Mark Newton, head of technicals Strategy at Fundstrat.

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It was quite a jump. The Nasdaq Composite COMP,
+3.82%,
which slipped into a bear market earlier this year and fell to a nearly 2 1/2 year low last week, rose 3.8% on Friday, posting its biggest one-day percentage gain since Nov. 4, 2020, making it its weekly Decline trimmed to a still impressive 2.8%.

The S&P 500 rose 2.4%, nearly halving its weekly decline. That took the US large-cap benchmark down 16.1% from its record close in early January, after ending Thursday just short of the 20% pullback that would fit the technical definition of a bear market. The Dow Jones Industrial Average DJIA,
+1.47%
was up 466.36, or 1.7%, down 2.1% weekly.

Read: Despite the recovery, the S&P 500 is hovering dangerously close to a bear market. Here the number counts

And all three major indexes have long, weekly losing streaks, with the S&P 500 and Nasdaq each down for six straight weeks, according to Dow Jones Market Data, the longest stretch since 2011 and 2012 respectively. The Dow posted its seventh consecutive week of losses — his longest streak since 2001.

The S&P 500 has yet to officially enter a bear market, but analysts see no shortage of bearish behavior.

As Jeff deGraaf, founder of Renaissance Macro Research, noted on Wednesday, correlations between stocks have been hovering in the 90th to 100th deciles, meaning stocks have been trading in lockstep largely in unison — “one of the defining characteristics of a bear market.”

While the S&P 500 has moved “uncomfortably close” to a bear market, it’s important to remember that large falls in stock markets are normal and common, analysts said. Barron’s noted that since 1950 the stock market has experienced 10 bearish pullbacks and numerous other corrections and other significant pullbacks.

But a downturn after the speed and magnitude of the recent rally can understandably unsettle investors, especially those who haven’t experienced a volatile downturn, said Randy Frederick, managing director of trading and derivatives at the Schwab Center for Financial Research, in a phone interview.

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The rally “saw every single sector of the market rally,” he noted. “This is not a normal market,” and now the worm has turned as monetary and fiscal policies tighten in response to hot inflation.

The appropriate response, he said, is to follow the same tried-and-true but “boring” advice usually offered in volatile markets: stay diversified, hold many asset classes, and don’t panic or make sweeping portfolio changes in front.

“It’s not fun right now,” he said, but “that’s how real markets work.”

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