Marko Kolanovic and John Stoltzfus, two of the loudest stock bulls on all of Wall Street, were convinced of one thing at the outset of 2022: The Federal Reserve would go slow, very slow, with its plan to lift interest rates. Nevermind that inflation had already soared to its highest level in four decades. The rate increases, they said, would come in increments so small that financial markets would barely feel them.
And so Kolanovic, JPMorgan Chase's co-head of global research, predicted a broad rally. He and his team pinned the S&P 500 Index at 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 personalities at big-name firms — are the public faces of what can only be described as the blindsiding of Wall Street. With few exceptions, the best and brightest in stock and bond markets failed to appreciate how the inflation outbreak would upend the investing world in 2022. They failed to anticipate how the Fed would react — the rate increases came at a torrid, not measured, pace — and failed to foresee how that, in turn, would trigger the worst simultaneous rout in stocks and bonds since at least the 1970s.
There are 865 actively managed stock mutual funds domiciled in the US with at least US$1 billion ($1.34 billion) in assets. On average, they lost 19% in 2022. Equity-loving hedge funds got hammered, too. On the bond side — a universe of 200 funds of a similar size — the average decline was 12%. A majority of them fared worse than the indexes they use as benchmarks to gauge their performance. Prominent among those was Western Asset Management's biggest mutual fund — the Core Plus Bond Fund.
Ken Leech, the company's chief investment officer, was, just like Kolanovic and Stoltzfus, convinced the Fed was in no hurry. In late 2021, he predicted there might not even be any rate hikes at all in 2022. The fund, a US$27 billion powerhouse, lost 18%. It underperformed 99% of comparable funds.
“A 40-year bull market,” says William Eigen, a bond investor at JPMorgan Asset Management and one of those rare exceptions who had positioned his fund to avert the pain to come, “does funny things to you.” It sears core principles into the brain that are hard to erase. Ever since the late 1980s, young traders, investors and analysts have been schooled in the ways of the Fed put, a belief that policy makers were always there to prop up markets in moments of turbulence — by scaling back plans to raise rates or outright cutting them — and, therefore, you should buy the dip.
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‘Like a Mugging’
The magnitude of the rout this year, to be fair, was hard to foresee. Both Leech and Stoltzfus, when contacted for comment, cited the unexpected shocks to the global economy that reverberated across markets. There was, for instance, China's insistence on sticking to its Covid Zero policy for most of the year and Russia's invasion of Ukraine. “This was really like a mugging the way it happened,” Stoltzfus said in an interview. “You had China, you had Russia, and then you had the process of the Fed doing what it finally had to do.”
Leech called the year “particularly challenging,” but noted that the fund's performance has started to improve. It’s gained 3.6% this quarter. “Recognizing changes in the 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-markets model portfolio he oversees. It posted a positive return this year, he said in a statement, as winning bets on commodities and bonds offset the wrong-way wagers on stocks. A year ago, he and the JPMorgan team had predicted some of the surge in yields in 2022, saying those on benchmark 10-year Treasuries would climb to 2.25%. They hovered at 3.88% late Wednesday.
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The Fed Put
It was in the aftermath of the last big inflation outbreak in the US that the Fed put axiom was born. With consumer prices stable once again by the mid-1980s, central bankers were free to focus primarily on supporting economic growth, jobs and, in the process, buoy stocks and bonds.
That the put is dead, for now, at least, in this new era of high inflation, hasn’t quite sunk in on many trading floors. Eigen sees this in the way traders clamour for a “Fed pivot.” By pivot, they mean a move away from sharp rate hikes and toward cuts meant to stave off a recession. This has led them to repeatedly bid up prices of bonds and stocks in fleeting relief rallies that sputter and crash when Fed Chair Jerome Powell forcefully reiterates that he and the board are forging ahead with rate increases 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 days, it too flamed out.
Sowing Market Confusion
Powell made mistakes, too, that added to the confusion in markets. Throughout 2020 and much of 2021, he expressed confidence again and again that the surge in prices sparked by supply-chain snarls and trillions of dollars in stimulus was transitory and would largely fade away on its own.
These comments only reinforced investors' conviction that the low-rates era was here to stay. In June of last year, they bet in the bond market that inflation would slow to around 3% over the next 12 months and that, as a result, the Fed would only have to raise its benchmark rate to about 0.4% by the end of 2022. The error was so great — inflation soared to as high as 9% and the Fed has lifted it key rate to more than 4% — that it laid the foundation for investors' broader misfire across markets. (Over in the corner where the bankers sit, things went awry too. They doled out tens of billions of dollars in loans to private-equity firms that have since plummeted in value.)
And yet, despite how badly they got burned by underestimating inflation, many in the investing community remain convinced that Powell, for all his tough talk, is getting ready to make that pivot. Consensus in the futures market has the first rate cut coming less than five months after the final hike. History shows the gap is typically more than double that length.
It’s ironic, in hindsight, that there was so much schadenfreude on display across Wall Street as the amateurs on Reddit got burned when their GameStop shares and Shiba Inu coins crashed in late 2021. This was proof, the pros snickered, that investing was best left to them. And yet, the mentality that felled the twenty-something-year-old bros chasing meme stock mania in the early days of the pandemic isn't ultimately all that different from the model taught at the country's elite financial institutions — markets only go up because, well, the Fed.
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“If you were rich and famous by the end of 2020, you were famous because of low rates,” says Andrew Beer, a managing member at Dynamic Beta whose exchange-traded fund is up 21% this year, thanks in part to a wager against bonds. “Your business, your fortune, your success was tied to low rates.”
This, he posits, has made it hard for investors like, say, Cathie Wood, the tech evangelist whose fund ARK Innovation has been in free-fall for over a year now, to rethink their approach. Rising rates, and the way they force investors to discount future corporate earnings, are particularly damaging to tech stocks. “When you see the world changing,” Beer says, “you have to take the other position because you're hoping and praying every day that the world isn't changing.”
There are some signs that the re-education of Wall Street is slowly underway.
In early December, as year-ahead forecasts started coming in, a consensus among strategists quickly formed that hadn't been seen since at least 1999: the S&P 500 would post an annual decline. Among those who ratcheted down their expectations is Drew Pettit. The 33-year-old Citigroup strategist says he can clearly see now the risks of having “basically grown up in a low interest rates, stocks want to go to the moon type of world.” He, too, had been in the camp predicting the S&P would end 2022 over 5,000. He's got it at just 4,000 by the end of next year. “Going forward,” he says, gains are “going to be a little bit harder to come by.”
Kolanovic has also started to turn more bearish on equities. His team put its call at 4,200. And Stoltzfus is at 4,400. That still implies a double-digit rally from here, true, but, given where he was this summer, it marks a radical shift. Back then, Stoltzfus was as bold and bullish as ever, predicting that the market was poised to erase all of the year's losses and soar to his 5,330 target. That'd have required a 40% gain in just over six months.
“We think we’re walking in the right direction,” he said in an interview in late June, “and we think the light at the end of the tunnel is not the headlamp of a locomotive but rather it’s sunlight.”
For a brief period, it looked like Stoltzfus was on to something. One of those Fed pivot rallies that Eigen finds so curious kicked in and, in a matter of weeks, the S&P 500 had jumped 17%. At some point, of course, the Fed will indeed shift its policy focus and one of these rallies will be proven right. It's inevitable. But this wasn't the one. In late August, Powell took the stage at Jackson Hole and delivered a terse inflation-must-be-crushed message.
And stocks and bonds began to fall once again.
