Looming S&P 500 Bear Case Sees 15% Drop on Fed Balance-Sheet Unwind

(Bloomberg) -- Bulls getting comfortable with Federal Reserve rate-hike policy have another threat to contend with, one that a team at Morgan Stanley says has the potential to send stocks to fresh lows.

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It’s the unwinding of a decade-old program to flood the economy with cash, known colloquially as quantitative easing, and now, as it’s undone, quantitative tightening. While rate increases get all the blame for this year’s bear market, an analysis by Morgan Stanley’s sales and trading team suggests the balance-sheet procedures have had more sway on equities in 2022, explaining virtually all their twists and turns.

Anyone expecting a slowdown in the pace of rate hikes to help equities emerge from the yearlong bear market may get a wakeup call from the ongoing impact of the Fed’s QT program, wrote the team whose members include Christopher Metli. They say the S&P 500 will drop as much as 15% by March, based on historic patterns and projected money flows in coming months.

“While the market is currently hyper focused on the Fed slowing the pace of hikes – which could still take stocks higher in the near-term – the elephant in the room is QT,” Metli and his colleagues wrote in a note earlier this month.

That the Fed remains the single biggest influence on equity markets was display Monday, when fresh hawkish rhetoric from policy makers sent the S&P 500 to a 1.5% loss. Down 17% for the year, the index is poised for its worst annual performance since the 2008 financial crisis.

QT is a key part of the monetary system that controls the amount of liquidity that affects asset prices. Just as the Fed’s bond purchases during the pandemic crisis helped inflate equity prices, their withdrawal is set to do the opposite by draining money out of stocks.

“QE mattered on the way up, and QT has mattered on the way down -- but the damage is not done yet,” the Morgan Stanley team wrote.

To track broad money flows, the team include three major inputs in their liquidity model: changes in the Fed’s balance sheet; the Treasury General Account (TGA), or Treasury cash held at the central bank; and Reverse Repo Facilities (RRP), or cash parked at the Fed by money market funds and others.

The mechanics are complicated but in the simplest terms, a rise in Fed’s balance sheet means an expansion in liquidity that bodes well for stocks, while an increase in TGA or RRP suggests a contraction in liquidity with the potential to spell trouble.

Taking into account all three factors, Metli and his colleagues found that the liquidity measure and the S&P 500 have demonstrated a tight linkage over most of the past 10 years, with six-month correlation reaching 0.70. (A reading of 1 means in-sync moves.)

As the S&P 500 sold off from March to June, liquidity fell sharply, according to Morgan Stanley. The rebound since September has come as the firm estimates $200 billion of money poured back in.

With Fed QT running at a pace of $95 billion a month and the Treasury forecasting its cash balance to rise by $200 billion into yearend, that amounts to a squeezing of liquidity that alone implies an 8% drop for the S&P 500 by the end of December, according to their model.

“That liquidity drain will be very hard to fight,” they warned.

The team says these correlations are likely to break once the balance sheet and excess liquidity from QE normalizes. Yet for now, they say, it’d be a mistake to ignore the risk of thinning liquidity.

Opinions differ on the influence of QT on asset prices. In August, Bank of America Corp. strategist Savita Subramanian estimated that QE has explained more than 50% of the change in the S&P 500’s price-earnings multiples since 2010, and the planned QT would shave 7% off the index’s value, all else equal.

Equity bulls say forces such as corporate earnings underpinned the S&P 500’s seven-fold rally since March 2009 through its latest peak in January. Yet one popular case among bears holds that all the gains were built on Fed support that saw its balance sheet expanding to record. Once the stimulus is rolled back, the thinking goes, that’d cause trouble.

Doug Ramsey, Leuthold Group’s chief investment officer, says the Fed’s monetary tightening is worsening a liquidity crunch at a time when an expanding economy is simultaneously depleting it.

All but one of the firm’s 14 monetary/liquidity indicators, such as loan demand and Treasury yield curve, are rated negative. One gauge, known as Marshallian K that tracks the gap in rates of growth in money supply and gross domestic product, fell in September to a four-decade low.

“These measures imply there’s no longer enough money to finance production of those goods and to support a stock market that’s still far from cheap,” Ramsey wrote in a note earlier this month. “The liquidity feast is now a famine.”

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