The US Federal Reserve (FED) continues to fight inflation. This Wednesday, during its quarterly meeting, he decided to raise his rates by half a point with a target rate of 0.75% to 1% by the end of the year.
Since the beginning of COVID-19, the Fed has increased its balance sheet by more than 50% to support markets, unprecedented in history.
This strategy proved to be relevant as the S & P500 rose more than 120% after a low COVID level.
The very sharp acceleration of the Fed’s balance sheet since 2020 after COVID has greatly contributed to the growth of risky assets.
This influx of liquidity also contributed to the formation of bubbles, especially in the technology sector, one of those most valued.
During this period, valuation ratios rose to certain values, and operators were very selective in their distribution of shares.
A year later, we are no longer in the same paradigm with a particularly tight market for stocks that receive the highest premiums (Zoom, Shopify, Coinbase, Esker, Robinhood, etc.). All these stocks have lost 50 to 70% since their historic high.
Can rates catch up with inflation?
Historically, as we can see in this chart, interest rates follow inflation.
Taylor’s rule recommends that the Federal Reserve raise interest rates when inflation is high or when employment exceeds full employment, and vice versa.
Based on this rule, the US Federal Reserve should raise the rate by 5.5%.
However, his goal this year increased by 0.75% -1%.
The end of “easy money” in the markets
Central banks are now facing a very complex equation.
The latter will reduce their balance sheets and raise key rates in an environment that already seems to be weakened by fears of stagflation (high inflation and declining economic activity).
Since the beginning of the year, we have already seen a more selective market, which refuses to increase shares in favor value which manages to hold back after many years of low efficiency compared to rising stocks. And this trend is likely to persist, at least for the next few years.
How to work in markets in conditions of stagflation?
A stagflationary environment seems to be emerging in almost all Western stock markets.
Stagflation is an economic concept that induces a decline in economic activity and rising inflation.
This situation has historically been very negative for financial markets, but has been positive for precious metals such as gold, for example, which can benefit greatly from this situation.
In this particularly uncertain and risk-averse environment, it is advisable to reduce its allocation to rising stocks and be much more selective about the securities in the portfolio.
The advantage of stocks can be a profitable choice.
Sliman Himora is an independent analyst and trader. After spending 2 years in a private fund where he gritted his teeth, he specializes in the American market and is particularly well versed in macroeconomics. You can find him on Twitter (@HimoraSlimane).