The prevailing narrative in financial markets is that the Federal Reserve (Fed) is significantly behind in its monetary policy and that, by accelerating its pace of rate hikes, it will almost inevitably trigger a recession in the US. This explains why the S&P 500 has fallen by approximately 10% this year.

Of course, these fears have been fueled by geopolitical risks and, more recently, by expectations that Chinese demand will collapse due to lockdowns.

This week, we would like to highlight several points that contradict the prevailing view in the market:

1. The Fed may not be so far behind. The Treasury bond market is projecting a 3% increase in rates, reaching a rate of 3.2% in 2023. In addition, the financial conditions index has adjusted by more than 1.5% from its low. In other words, even though the Fed hasn't done much yet, the markets are already discounting a very significant move.

Meanwhile, measures of inflation expectations also support the view that the Federal Reserve is not perceived as being as "behind the curve" as some market observers suggest. Equilibrium inflation rates, measured by the spread between Treasury Inflation-Protected Securities (TIPS) and Treasury bonds with comparable maturities, stand at 3.4% for 5-year bonds and 3.0% for 10-year bonds.

Another long-term measure, the markets' estimate of what the 5-year forward equilibrium rates will be, shows inflation expectations at 2.5%, which is only modestly above the Federal Reserve's 2% target considering that the CPI has historically exceeded the Federal Reserve's preferred PCE inflation measure by about 30 basis points.

2. Favorable economic environment. Economic indicators are firmly in expansionary territory, and growth of approximately 3% is forecast for the U.S. economy.

3. Favorable earnings environment. With nearly 40% of S&P 500 companies having already reported first-quarter results, 74% have exceeded earnings expectations. This has led to an upward revision of earnings growth to a consensus of 10% for the year. 

4. Investor sentiment is very pessimistic, with the sentiment indicator currently at 2.2 standard deviations below its mean. This is a rare occurrence and is usually followed by positive stock returns.

5. In recent weeks, China's top priority has been to contain Omicron outbreaks. Now the goal is to balance outbreak containment and economic growth. This suggests that the government may adjust its "zero-tolerance" policy to allow for some flexibility, and the recent decline in cases may point in that direction.

Details from a Politburo meeting this week commit to more political support to meet the country's economic growth target for the year: i) strengthening macro adjustments, ii) supporting the healthy growth of platform companies, iii) planning incremental policy tools, iv) making efforts to boost domestic consumption, and v) promoting healthy development of the real estate market. Chinese leaders also pledged to ensure "supply chains in key sectors" and smooth transportation logistics, committing to "respond positively" to demands from foreign-invested enterprises for a smoother business operating environment.

The latest stimulus pledge comes just days after Chinese President Xi highlighted infrastructure as a major focus for the government as growth is under pressure.

All in all, if a recession is avoided (the base case scenario for now), history shows us that staying invested in stocks is the right strategy. However, even if a recession occurs in the coming years, it is too early to reduce equity exposure.

Humberto Mora

Gerente de Inversiones Finanzas y Negocios Corredora de Bolsa