Stocks are tumbling as the Federal Reserve’s tighter monetary policy forces investors to rethink the entire stock market.
The S&P 500 is down 9.2 percent in January, its worst month since coronavirus shuttered the economy in March 2020. High-multiple growth stocks have fared especially badly, delivering their worst performance versus value stocks since the Dotcom bubble deflated in early 2001.
“Inflation remains well above our longer-run goal of 2 percent,” Chairman Jerome Powell said on Wednesday. “Bottlenecks and supply constraints are limiting how quickly production can respond to higher demand in the near term. These problems have been larger and longer lasting than anticipated.”
While the Fed has only officially signaled three interest-rate hikes, CME’s FedWatch tool shows the market is pricing in at least five increases this year. The first quarter-point move is expected on March 16, followed by similar adjustments on May 4 and June 15.
The new environment, spurred by rising inflation, creates several potential risks for stock-market investors:
- Higher rates can lower stock-market valuations.
- Higher rates can slow the economy.
- Tighter monetary policy can flatten the yield curve.
Higher Rates Can Lower Stock Market Valuations
Investors attempting to value stocks discount future earnings using interest rates. Just as lower borrowing costs can let homebuyers afford bigger houses, lower rates can justify higher prices for stocks. Ample liquidity and easy money can encourage risk taking in assets like equities. But just the opposite is true when the supports are taken away.
Higher Rates Can Slow the Economy
The whole purpose of higher interest rates is to reduce inflation by slowing the economy. Companies relying on consumption and business spending may experience slowdowns. That includes many industrial stocks, transportation companies and retailers. It also applies to homebuilders, which are interest-rate sensitive.
Tighter Monetary Policy Can Flatten the Yield Curve
Another result of the new environment could be a flatter yield curve. Fed hikes impact the overnight target rate, which effectively raises short-term interest rates. The other result, a slower economy, drags down longer-term rates.
That compression of higher short-term rates with lower long-term rates is known as a flatter yield curve. It can weigh on banks and financials that profit from borrowing in the short term and lending in the longer term.
Inflation and the Economy
“Price increases have now spread to a broader range of goods and services,” Powell said this week. “We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched.”
The Commerce Department also reported that gross domestic product expanded by 6.9 percent in the fourth quarter, much stronger than the 5.5 percent average forecast. Inventory building played a big role in the beat as companies restocked from the pandemic’s shortages. While that kind of news may appear bullish on the surface, it can have the opposite effect because it gives the Fed more reason to increase interest rates.
The strong labor market, with rising wages and millions of unfilled jobs, is another potential risk because it gives the Fed leeway to tighten policy.
Don’t Fight the Fed?
“Don’t fight the Fed,” is a common axiom in the market. It cautions investors to avoid taking positions against the policy direction of the central bank.
This saying could be especially relevant now because we’re at the start of a clear, and relatively long, hiking cycle. Investors know the economy faces the fastest inflation in generations. They also know that the strong economy makes it easier for the Fed to do the hard work now. With two years of steady gains under their belts, money managers seem to be taking profits and hitting the sidelines for the time being.
The initial reaction was violent because big moves typically increase correlation across the market. As investors adjust to the new normal, different kinds of stocks may emerge as new leaders. It could be a different kind of market, rewarding patience and careful observation.
Keep reading Market Insights as we track the changing landscape.