By Yasin Ebrahim

Investing.com — After years of propping up stocks, the Federal Reserve is now faced with the task of piercing the ‘wealth bubble’ to dampen inflation. However, deflating this bubble will likely put the economy into recession and cause the market’s value to drop by about 55%.

“We believe that the Fed will land us in a recession,” Phillip Toews, CEO & Portfolio Manager of Toews Asset Management told Investing.com earlier this week. A recession could tip stocks into an “average bear market or worst, with losses of about 35%,” Towers added, pointing to the historical average decline in bear markets.  

Stocks are at risk of losing nearly half their value during a recession, with an average bear market decline of 18%.

The Wealth Effect is All in the Fed’s Hands

Over a decade, low interest rates as well as market-friendly conditions for monetary policy and fiscal stimulus have increased the assets in consumer balances. The result has been a wealth mountain that stimulates spending and fuels inflation.

Tech and other growth sectors played an important role in equity investors’ wealth creation.

“When we looked at what the vast majority of new clients that came into our wealth management practice, the FANG stocks were a big chunk of their portfolio,” Eric Diton, President and Managing Director at The Wealth Alliance, said in a recent interview with Investing.com.

However, in an environment of rising rates growth stocks have been less appealing due to their higher valuations.

“I’ve been saying for the last year, you can own tech but not in an S&P 500 style, where five or six stocks make up about 25% of your portfolio. Those people are really getting hurt right now,” Diton added.

Initial Signs that the Fed is Poking At The Wealth Bubble

There are early signs that the Fed’s policy measures are putting the squeeze on consumer wealth.

The Federal Reserve reported on Thursday that U.S. household assets fell in the first quarter 2022 for the second time in two-years.

According to the Fed’s quarterly snapshot, the net worth of households fell to $149.3 trillion after an all-time high at $149.8 trillion last year.

The slump in stock prices of $3 trillion was the main reason for the drop, however rising property values (which climbed another $1.7 trillion during the quarter) kept losses at bay.

Home prices, which topped 20.6% in March from a year earlier, have continued to surge even as mortgage rates have climbed, according to the latest S&P CoreLogic Case-Shiller Home Price Index.

To deflate the wealth bubble, there will need to be a decrease in home and stock prices.  

“The Fed supported the markets for about 15 years, but now has an incentive to prick the [wealth] bubble and cause financial asset prices and home prices to deflate as a way of addressing inflation, Toews said.”

Hard Landing or Crash Landing

Undoing the ‘wealth affect’ or making consumers feel less well-off to discourage spending and bring down inflation will also rely on the Fed’s ability to restore the demand and supply imbalance in the labor market to cool wage growth.

“As long as you have faster wage inflation  … the Fed won’t come close to getting anywhere near 2% or 3% inflation,” Chief Strategist at Spouting Rock Asset Management Rhys Williams told Investing.com in an interview on Friday.

While acknowledging the tight labor market is a “tough” issue for the Fed, Williams said there is “potential that in 2023 that the ‘great resignation’ becomes a ‘great application’ as you’re not going to have so many job openings available.”

“That’s already starting to happen … it’s concentrated now in blockchain technology and software companies, some internet-based companies but it’s going to get broader as the year unfolds,” Williams added.

While there is consensus that there will be a recession, some are debating whether an economic slowdown or a deeper one may occur. A major recession will not likely be prevented by the accumulation of wealth over time and the absence of significant capital spending from businesses.

“We didn’t really have the mother of all capex spending cycles to generate a lot of excess capacity and the consumer is strong,” Williams said. “Those two factors are probably what prevents a major recession.”