A "stubborn" Federal Reserve has increased the likelihood of a prolonged recession, according to Axonic Capital's Peter Cecchini.
That's because the Fed could cause economic whiplash that leads it to cutting interest rates sooner than expected.
"The 1970's drawdown scenario of almost 50% for the S&P 500 is becoming all the more likely," Cecchini said.
The Federal Reserve's decision to hike interest rates by 75 basis points this week only increases the chances of a prolonged economic recession and a deep sell-off in the stock market, according to Axonic Capital's Peter Cecchini.
That's because the Fed is just now getting aggressive in tightening financial conditions as data begins to show a slow-down in inflation. That scenario can cause significant policy whiplash that leads to economic hardship for millions, according to Cecchini.
"Stifling domestic demand with too-late rate hikes could now result in a prolonged recession, especially because policy works with a three-to-nine-month lag on the economy," Cecchini said, adding that the Fed's stubbornness to wait so long to raise interest rates could lead to a costly policy whipsaw.
That's because while the Fed is trying to tame inflation by lowering consumer demand for goods and services, it's actually supply side constraints and higher commodity prices that are driving the bulk of inflation, a side of the economic equation that the Fed exerts little influence over.
That's why it would have paid dividends for the Fed to reign in consumer demand by kicking off its interest rate hike cycle earlier than it did, as that would have helped tame demand before supply chain constraints and higher oil prices added fuel to the fire.
Instead, the Fed is embarking on a fast and furious interest rate hike path that will likely include two back-to-back 75 basis point interest rate hikes in July, which followed a 25 basis point and a 50 basis point interest rate hike in March and May, respectively. In late 2021, the Fed had only expected to raise interest rates once in 2022.
All of this means stock market investors could still see significantly more pain ahead, even after accounting for the S&P 500's year-to-date decline of more than 20%.
"Unfortunately, the risk-off scenario we articulated in late 2021 is beginning to play out, and the 1970's drawdown scenario of almost 50% for the S&P 500 is becoming all the more likely," Cecchini said.
A 50% decline in the S&P 500 from its January peak would send the index to the 2,400 level, representing potential downside of more than 30% from current levels.
A double whammy of contracting valuations and lower earnings forecasts "should occur," Cecchini said, sparking more downside in the market. Despite the recent market volatility, a 40-year record in inflation, and rising interest rates, Wall Street analysts haven't budged in lowering their 2022 corporate earnings estimates.
That signals that there's still room for investors to be disappointed by earnings, which could fuel further selling pressure as earnings typically drive stock prices in the long-term.
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