Bloomberg: Marko Kolanovic and John Stoltzfus, two of the loudest stock bulls on all of Wall Street, entered 2022 with one thing: The Federal Reserve would be slow, very slow with its plan to raise interest rates. Notwithstanding that inflation had already risen to its highest level in four decades. The rate hikes, they said, would come in such small increments that the financial markets would hardly notice them.
And so Kolanovic, co-head of global research at JPMorgan Chase, predicted a broad rally. He and his team have pinned the S&P 500 Index to 5,050 by the end of 2022. Stoltzfus, the chief investment strategist at Oppenheimer, was even bolder: 5,330.
They were off by more than 1,000 points.
The two men – high-profile figures in big-name companies – are the public faces of what can only be described as the blind side of Wall Street. With few exceptions, the best and brightest in the stock and bond markets failed to appreciate how the inflation eruption would turn the investment world upside down in 2022. They could not predict how the Fed would react — the rate hikes were occurring at a rapid, unmeasured pace — and how that, in turn, would trigger the worst simultaneous flight in stocks and bonds since at least the 1970s.
There are 865 actively managed US-based equity funds with at least $1 billion in assets. On average, they lost 19% in 2022. Equity-loving hedge funds have also been hit hard. On the fixed income side – a universe of 200 similarly sized funds – the average decline was 12%. A majority of them underperformed the indices they use as benchmarks to measure their performance. Among them was Western Asset Management’s largest mutual fund – the Core Plus Bond Fund.
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Ken Leech, the company’s chief investment officer, agreed with Kolanovic and Stoltzfus that the Fed was in no hurry. In late 2021, he predicted there might be no rate hikes at all in 2022. The fund, a $27 billion powerhouse, fell 18%. It underperformed 99% of peer funds.
“A 40-year bull market,” says William Eigen, a bond investor at JPMorgan Asset Management and one of the rare exceptions who positioned his fund to avert the pain to come, “does weird things to you.” It burns core principles into the brain that are difficult to erase. Since the late 1980s, young traders, investors and analysts have been schooled in the nature of the Fed put, in the belief that policymakers have always been there to support markets in turbulent moments – by proposing rate hikes or… to a full cut they scaled back – and that’s why you should buy the dip.
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“Like a Raid”
The extent of the loss that year was, to be fair, difficult to predict. When asked, both Leech and Stoltzfus mentioned the unexpected shocks to the global economy that were impacting markets. There was, for example, China’s insistence on sticking to its Covid-Zero policy for most of the year and Russia’s invasion of Ukraine. “It was really like a robbery the way it happened,” Stoltzfus said in an interview. “You had China, you had Russia, and then you had the Fed’s process of doing what it eventually had to do.”
Leech described the year as “particularly challenging” but noted that the fund’s performance had started to improve. It’s up 3.6% this quarter. “Given the changing macro environment, we have made adjustments to our broad market portfolios and believe the fund is well positioned to benefit from a global recovery,” Leech said in a statement.
Kolanovic pointed to the performance of a broader cross-market model portfolio that he oversees. It has posted a positive return this year, he said in a statement, as profit bets on commodities and bonds offset incorrect bets on stocks. A year ago, he and the team at JPMorgan predicted part of the rise in yields in 2022, saying that the benchmark 10-year Treasury would rise to 2.25%. They were hovering at 3.88% late Wednesday.
The Fed Put
After the last major burst of inflation in the US, the Fed’s put axiom was born. When consumer prices stabilized again in the mid-1980s, central bankers were able to focus primarily on supporting economic growth and jobs, while supporting stocks and bonds.
The fact that the put is dead in this new era of high inflation, at least for the time being, has not yet really arrived on many trading floors. Eigen sees this in the way traders are clamoring for a “Fed pivot.” By fulcrum, they mean moving away from sharp rate hikes and toward rate cuts designed to stave off a recession. This has prompted them to repeatedly push the prices of bonds and stocks higher in fleeting recovery rallies that falter and crash when Fed Chair Jerome Powell emphatically reiterates that he and the board are pushing rate hikes until inflation is back under control. “This is about the fourth Fed pivot rally we’ve had this year,” Eigen said as he watched markets grind higher one morning in late November. Within a few days it, too, burned out.
sow market confusion
Powell also made mistakes that added to the confusion in the markets. Throughout 2020 and much of 2021, he consistently voiced confidence that the price surge fueled by supply chain snarls and trillions of dollars in stimulus was temporary and would largely subside on its own.
These comments only reinforced investors’ belief that the low interest rate era was here to stay. Last June, they bet the bond market that inflation would slow to about 3% over the next 12 months and therefore the Fed would only have to raise its benchmark rate to about 0.4% by the end of 2022. The mistake was so big – inflation has soared to as high as 9% and the Fed has raised interest rates to over 4% – laying the groundwork for investors’ broader misfires in the markets. (Things went wrong over in the corner where the bankers sit, too. They made tens of billions of dollars in loans to private equity firms that have since fallen in value.)
And yet, despite being badly burned by the underestimation of inflation, many in the investment community remain convinced that Powell, for all his harsh words, is preparing to hit that tipping point. The consensus in the futures market is that the first rate cut will come less than five months after the last hike. History shows that the gap is typically more than twice as long.
In hindsight, it’s ironic that there was so much glee on Wall Street as amateurs burned on Reddit in late 2021 as their GameStop shares and Shiba Inu coins plummeted. This was proof, the pros snickered, that it was best to stop investing to them. And yet, ultimately, the mentality displayed by the twenty-something brethren who chased meme stock mania in the early days of the pandemic isn’t all that different from the model being taught by the country’s elite financial institutions – markets are rising just because, well, the Fed.
“If you were rich and famous at the end of 2020, you were famous because of low interest rates,” says Andrew Beer, a managing director at Dynamic Beta, whose exchange-traded fund is up 21% this year, thanks in part to a bet against bonds. “Your business, your wealth, your success was tied to low interest rates.”
This, he posits, has made it difficult for investors such as Cathie Wood, the tech evangelist whose ARK Innovation fund has been in freefall for over a year, to reconsider their approach. Rising interest rates and the way they force investors to discount future corporate earnings are hurting tech stocks in particular. “When you see the world changing,” says Beer, “you have to take the other position because you’re hoping and praying every day that the world won’t change.”
There are some signs that Wall Street’s re-education is slowly progressing.
In early December, as the full-year guidance came in, a consensus quickly formed among strategists not seen since at least 1999: the S&P 500 would post an annual decline. Among those who have lowered their expectations is Drew Pettit. The 33-year-old Citigroup strategist says he can now clearly see the risks that “basically grew up in a low-interest-rate world, stocks want to go into the moon-type world.” He too had been in camp predicting the S&P 2022 would end above 5,000. He’d made it to just 4,000 by the end of next year. “Going forward,” he says, “profits are going to be a little harder to come by.”
Kolanovic has also started to make stocks more bearish. His team named 4,200. And Stoltzfus is at 4,400. While that still implies a double-digit rally from here, it marks a radical shift given where he’s been this summer. Back then, Stoltzfus was as bold and optimistic as ever, predicting that the market was poised to erase all of the year’s losses and rally to its target of 5,330. That would have required a 40% gain in just over six months.
“We think we’re going in the right direction,” he said in an interview in late June, “and we think the light at the end of the tunnel isn’t a locomotive headlight, it’s sunlight.”
For a brief period, it looked like Stoltzfus had something on his trail. One of those Fed pivot rallies that Eigen finds so odd set in, and within weeks the S&P 500 was up 17%. Eventually, of course, the Fed will change its policy focus and one of those rallies will prove correct. It’s inevitable. But it wasn’t. In late August, Powell took the stage at Jackson Hole and delivered a succinct message that inflation must be crushed.
And stocks and bonds started falling again.
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