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

Stock investors who are optimistic about Federal Reserve's rate-hike policy have another threat to contend with, one that analysts at Morgan Stanley say has the potential to send stocks to fresh lows.

As rate hikes get all the blame for this year's bear market, an analysis by Morgan Stanley suggests the Fed's balance-sheet procedure of quantitative tightening (QT) had more sway on equities in 2022, explaining nearly all their twists and turns.

"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," wrote Christopher Metli, an analyst at Morgan Stanley's sales and trading team. His team believes S&P 500 will drop as much as 15% by next March, based on historic patterns and projected money flows in the coming months.

To track broad money flows, the team includes 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 stored 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 is beneficial for stocks, while an increase in TGA or RRP suggests a contraction in liquidity which could drag down the market.

Taking into account all three factors, Metli's team found that the liquidity measures and the S&P 500 have demonstrated a close connection over the past 10 years, with the six-month correlation reaching 0.70.

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

With Fed's QT running at a pace of $95 billion a month and the Treasury forecasting its cash balance to increase by $200 billion before yearend, that amounts to a drop in liquidity which could lead to an 8% decline for the S&P 500 by the end of December, according to their model.

In addition, the team says this correlation is likely to break once Fed's balance sheet and excess liquidity normalize. Yet before that, it would be a mistake to ignore the risk of thinning liquidity.