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July 22, 2022 | 3 Minute Read
Global Head of Market Strategy, Strategic Advisory Solutions
While every equity market correction is unique and distinct, we observe two common drivers: monetary policy and deleveraging. With the S&P 500 now down more than -15% from its January peak, we believe that the driving force behind the current episode is monetary policy.1 The Federal Reserve (Fed) has aggressively engineered tighter financial conditions with the express goal of reducing aggregate demand and ultimately inflation. As a result, the market has experienced higher short- and long-term interest rates, wider credit spreads, a stronger US dollar, and most notably, lower equity prices.
Exhibit 1 highlights past equity market drawdowns in which monetary policy was a key driver of market corrections. On average, these corrections bottomed when the Fed shifted their policy stance from tightening to easing. Such an occurrence was present in all but one of those corrections over the past seven decades. On the other hand, economic and activity data, illustrated through the ISM manufacturing index, proved to be less closely tied to the market trough in such episodes. In our view, the cause of the current bear market is fairly clear: elevated geopolitical tensions, decelerating economic growth, and poor market liquidity have all been contributing factors, but none have been as consequential as the Fed’s commitment to taming inflation.
Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. As of June 14, 2022. “Drawdown” refers to the S&P 500 maximum peak-to-trough price decline during each specific period. “Trough” refers to the minimum S&P 500 price within each specific drawdown. “+/-3m” refers to three months before or after market bottom. “Monetary” refers to bear markets primarily caused by tightening in monetary policy. Past performance does not guarantee future results, which may vary.
In the same way that the Fed is inextricably linked to the market’s descent, it is likely to find itself playing a role in a market ascent as well. We believe investors are awaiting a shift in policy direction from the central bank. That shift does not necessarily require policy easing, which we think would only come amid a recession. However, it does require clear signs of inflation containment and subsequently reduced tightening risks.
To date, inflation has largely moved upwards. Each time in the past year that the economy has claimed peak inflation, the consumer price index has proven to reach to a new high. When the Fed, and consequently the market, are convinced that the worst prints are truly behind us, sentiment may turn. We think multi-month trends in inflationary data are likely to be more telling than individual data points that are often subject to fluctuation and later revisions.
Ultimately, the old adage “Don’t fight the Fed” may be both the problem and the solution. As such, we believe investors should look to inflation and potential shifts in the Fed’s stance to find the current market’s bottom.
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1 Source: Bloomberg and Goldman Sachs Asset Management. As of July 19, 2022
Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. As of July 19, 2022. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved. Past performance does not guarantee future results, which may vary.
“Fed” refers to the Federal Reserve.
“ISM manufacturing index” refers to the Institute for Supply Management Purchasing Managers’ Index.
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Date of first use: July 22, 2022. 285641-OTU-1640963