This Is A Risky Time For Stocks

This Is A Risky Time For Stocks
Stéphane Renevier, CFA

3 months ago2 mins

Most investors know that the Federal Reserve’s (the Fed’s) monetary policy is a big driver of stock prices. In theory, when the Fed lowers interest rates or adds money into the economy through massive bond-buying programs or other means, it makes borrowing cheaper. Those things are referred to as “easing” (right side of the chart) and they typically encourage new investment or spending by companies and households, stimulating the economy and boosting stock returns. When the Fed is “tightening” (left side), the opposite happens.

But there’s easing and there’s easing. The economy (and, ultimately, the stock market) are stimulated not just by what the Fed does, but also by credit spreads – that is, the extra yield that investors demand for buying riskier corporate bonds. When these spreads get smaller, signaling easing credit conditions (top) and cheaper loans to companies, stocks often jump. They take it, essentially, as a sign that companies are in good shape and unlikely to default on their debt. But when spreads widen and credit tightens (bottom), stocks often stutter. That’s because investors are less confident that companies will pay back their debts, and that’s often a warning sign that things are on the verge of turning sour.

So you’d think: the toughest scenario for stocks is when both the Fed and credit are tightening. But, actually, it’s when the Fed eases while credit tightens (bottom right). See, when the Fed is tightening, it’s usually doing so to try to combat hot inflation, which is usually a consequence of a booming economy. So that tightening usually begins when the economy – and stocks – are looking strong. But, if those rate hikes hit too hard and shove the economy and the job market into a steep downturn, the Fed has to switch gears and ease. And it’s at that point that bond investors generally sense the defaults coming. So, the key driver of stock prices isn’t just whether the Fed eases. It’s also about the confidence of corporate bond investors in companies’ ability to repay their debts, especially in challenging times.

And that brings us to where we are now: the Fed says it is wrapping up its tightening phase, and the market is anticipating a shift toward easing. But this may not necessarily be the good news investors expect. The future direction of growth is critical: if it stays strong enough to allow for narrowing credit spreads, we’ll enter the top-right quadrant – a zone that’s been great for stocks historically. But if investor confidence wavers over corporate debt prospects, we could drift into the bottom-right quadrant, which is notoriously rough for stocks (although not every time). Investors lately have been an optimistic bunch and are betting the former – and they may be right. But you’d do well to remain aware things could also turn very sour. These are times of heightened risk.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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