Despite briefly entering correction territory on Monday (down 4.0% on the day at one point) the S&P 500 has fallen just 0.9% so far this week. Major indices pared big losses on both trading days this week, which is a buy signal for some investors.
But the risks for the S&P 500 remain to the downside. The prospect of higher short-term interest rates is flattening the yield curve. The pace of rate increases priced in is too fast to sustain current equity market valuations.
The Fed is stuck in a bind. A sharp rebound in asset prices (housing and equities) was necessary to generate a swift recovery from the pandemic slump in economic activity. But the economic cycle has become too firmly tied to housing and equities.
A self-fulfilling tendency, whereby the economy becomes over reliant on higher asset prices, creates a dilemma. It will be harder for the Fed to shift to a more dovish stance if the S&P 500 slides into correction again because of a global inflation spike that is not going to reverse soon.
There is still plenty of scope for stocks to fall further. A drop in equities could have a sizeable impact on the economy. Indirectly & directly held corporate equities (by households) as a share of GDP has risen to unprecedented levels even by dot-com standards.
Summary
- US households heavily exposed to equity drop
- Economy highly dependent on asset valuations
- Risks of upside surprise to ECI and PCE this week
