(Bloomberg Opinion) -- Once upon a time, Goldilocks saw inflation at 6.8% and knew the Federal Reserve would have to act. Worried about the value of her home and stock portfolio, she visited the Fed house. First, she saw Papa Fed Bear who was big and scary. “We’re in a bubble. I’m going to cause asset prices to crash, especially stock and real estate prices. Interest rates and the cost of capital will soar, leading to bankruptcies and major recession. Only after a major purge can healthy economic growth resume.”
Next Goldilocks met Baby Fed Bear, who was small and cute. “I won’t hurt your portfolio Goldilocks. I’ll just do a little cosmetic tightening and pull back at any sign of market unease or complaints from elected officials. The main thing is not to disrupt the economic healing from the pandemic.” But Goldilocks knew that was as scary as Papa Fed Bear. A timid, politicized Fed in the 1970s managed to drag down the economy without taming inflation, leading to stagflation and perverse government policies like wage and price controls.
Finally, Goldilocks found Mama Fed Bear. She promised firm tightening to deflate bubbles, clear out economic deadwood and limit inflation to 2%, while keeping real economic growth at least positive for the next year and setting the stage for years of robust growth afterward. “Let the politicians yell and scream, let the markets beg for mercy, I will hold a steady, independent course based on good data, firm theory and battle-tested models.”
I don’t know which of the three Fed Bears will show up in 2022, but all three are plausible enough that investors should diversify so none can cause fatal financial damage. Just as important, decisions should not be made on fairy tales but by sober consideration of the probabilities and likely magnitudes of the three scenarios.
The median forecast for 2022 seems to be that the Fed ends asset purchases early in 2022, and raises its target for the federal funds rate three times, or by 0.75 percentage point. Since 1954, the real total return on the S&P 500 Index -- including dividends but after inflation -- has been 3% in years when the fed funds target rate rises by 0.75 percentage point or more, versus 10% in other years. The chance of a 10% real decline is 21% in those years and a Papa Fed Bear 20% decline happens 8% of the time. Those are twice the 11% and 4% probabilities in years when the Fed does not raise the fed funds rate by 0.75 percentage point or more.
While a 3% average real return is not bad, for many investors it might not be worth the 16% volatility and the doubled crash risk of Fed tightening years. Moreover, 0.75 percentage point is only the median forecast, and there’s a good chance the Fed will be forced into more aggressive action with correspondingly larger effects on asset prices.
Optimistic investors are conditioned to think that poor market returns set the stage for future growth. But if we look at the average annualized total S&P 500 returns for the five years after a year in which the Fed tightens by 0.75 percentage point or more, they are somewhat worse — 5.4% annualized versus 6.7% — than five-year periods following years without 0.75 percentage point or more tightening.
What about the Baby Fed Bear scenario? What if the inflation rate remains above 6% for all 12 months of 2022? That’s just as bad for average stock market returns as Fed increases of 0.75 percentage point or more — a 3% average total real return for the S&P 500. But despite the low average returns, these years have sharply reduced volatility and crash risk. Only 5% of the time is the S&P 500 real total return worse than minus 10%, versus 13% in other years — and only 0.4% of the time is it a 20% or greater decline, versus 5% in other years. In the subsequent five years, investors enjoy an average 9.1% annualized real total return, versus 6.2% in other years. So, stock market investors need not fear Baby Fed Bear, despite the painful experience of the 1970s.
Averages from the past are not predictions of the future. Their use is in calibrating diversification. Your portfolio and financial plan should be capable of withstanding the full range of historical events if they are to have any hope of surviving what actually happens. Guessing the future can produce above-average returns, but prudent investors plan for being wrong as well as for being right.
In 2022, median forecasts and historical averages identify Papa Fed Bear as a major risk to asset prices. Expected real returns may be positive, but they’re modest, and crash risks seem to be about double their average level. Even five-year real return expectations seem reduced. That’s not a reason to flee stocks and other assets, but it’s a reason prepare for bad news and to be sure your allocations reflect your true risk tolerance. If you can find cost-effective tail-risk hedges, they may be more attractive than average.
On the other hand, most economists and commentators seem more concerned about Baby Fed Bear. They may be correct from the standpoint of long-term societal consequences, but the damage to investors would likely be in below-average asset real returns, rather than in high volatility or crash risk; and the five-year prospects would be quite good.
Of course, we all hope for Mama Fed Bear to cure our inflation, bubble and overleverage problems with a spoonful of sugar to help the medicine go down. My guess is that’s unlikely without progress on fiscal issues—not so much cutting spending and increasing taxes as moving from ideological brinksmanship to rational budgeting with honest numbers.
In most versions of the fairy tale, Goldilocks runs away from all three bears to the safety of her mother’s arms. She promises to be good and give up housebreaking and stealing food from wild animals. But there’s no running away from the three Fed Bears.
More From Other Writers at Bloomberg Opinion:
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.
©2022 Bloomberg L.P.