- Stocks are in for a world of pain in 2022 as an inflation-induced recession causes a bear market.
- That's according to Bank of America, which sees the S&P 500 falling below 4,000 later this year.
- "Hawkish Fed now wishes to address issues of wealth inequality & inflation… starts with overvalued stock market," BofA said.
Investors are in for a world of pain in 2022 as an inflation-induced recession will spark another correction in the stock market, Bank of America said in a Friday note.
"Inflation causes recessions," BofA stated bluntly, and right now, inflation is "out of control," according to the note.
Inflation has been running hot amid renewed demand from consumers as COVID-19 recedes, combined with ongoing supply chain disruptions and a spike in commodity prices due to Russia's invasion of Ukraine. Prices are rising at a pace that has not been seen in over 40 years.
And nearly all prior recessions have been preceded by inflation surges, including in the late 1960's, early 1970's, and in 2008. "Last dominos to drop in terms of recession expectations is higher yields and weaker dollar," BofA explained.
After the "inflation shock" comes the "rates shock," which will ultimately lead to a "recession shock," according to the note. And that recession will cause the S&P 500 to fall below the key 4,000 level by the end of 2022, BofA said, which represents potential downside of 11% from current levels.
Interest rates are top of mind for investors, especially after this week's Federal Reserve minutes, which revealed that the Fed plans to raise interest rates by 50 basis points in May. The minutes also revealed the Fed's plan to reduce its balance sheet by $95 billion per month later this year.
The Fed's balance sheet had ballooned to $9 trillion from pre-pandemic levels of about $4 trillion. "Fed balance sheet of $9 trillion to decline to $6.5 trillion by end of 2023. Quantitative tightening [is the] opposite of quantitative easing [which means] higher bond yields and higher volatility," BofA said.
"Quantitative easing was very bullish [for] financial assets. Quantitative tightening by design will be negative [for] financial assets," BofA explained. The Fed's practice of buying fixed income securities over the past two years was designed to provide liquidity to credit markets so companies could raise debt amid a global pandemic. That liquidity boost tends to eventually flow into stocks, creating buying pressure and pushing prices higher.
"[A] new era of belatedly hawkish Fed that suddenly now wishes to address issues of wealth inequality & inflation via monetary policy starts with overvalued stock market," BofA said.
That thinking lines up with former Fed President Bill Dudley, who said in an Op-ed earlier this week that the Fed needs to cause pain in the stock market to help rein in inflation.
"One thing is certain: To be effective, [The Fed] will have to inflict more losses on stock and bond investors than it has so far," Dudley said.
Ultimately, any drawdown in the S&P 500 to new lows this year would serve as significant whiplash for investors, but it would line up with a more than 100-year old bear market indicator that is prompting many traders to get serious about a potential recession: the steep sell-off in transportation stocks, known as Dow Theory.