Stocks have had the worst start to the year in over 50 years.
Wall Street is struggling to adjust to the new reality after a record-setting run fuelled by cheap money. The economic landscape has changed drastically since the Federal Reserve increased interest rates aggressively to combat high inflation.
The tech-heavy Nasdaq fell by 30%, while the broad-based S&P 500 has dropped by more than 20% at the halfway point. Both indexes are currently in bear market territory. The Dow Jones Industrial Average is also in correction. It is currently down more than 15% for the year.
Charles Bobrinskoy (Vice Chairman of Ariel Investments) says that when interest rates rise, it alters all the math. It changes the math of buying cars, houses, bonds, and it also changes the value tech stocks, whose future earnings are uncertain.
This means that Wall Street’s recent whipsawing, including the huge swings of over 1,000 points per day aEUR”, reflects investors’ real anxiety. They are worried that the Fed could tip the U.S. into a recession.
Although volatility is primarily caused by rising inflation and interest rates, it has also been exacerbated by many geopolitical risks. COVID-19 continues its wreak of havoc in China and lockdowns there, while global supply chains are still clogged and Russia’s invasion into Ukraine continues.
Investors tend to withdraw money from riskier areas of the economy when interest rates rise or borrowing costs go up. Stocks of high growth tech stocks and companies with high growth rates are often the first to fall.
This time it is no different. Netflix is the worst performing stock in the S&P 500, down 70%. This is a remarkable turnaround for a company whose share price soared during the pandemic. The streaming service was a lifeline for those locked down. Etsy is the second worst performer, a marketplace that sells art and crafts from artisans. It is down nearly 65%.
Energy is the only thing that has made stocks look good. Russia’s invasion in Ukraine drove oil and natural gases prices higher. Gasoline and diesel prices set new records. Global energy giants have benefited from the rise in commodities prices. Many of them made record profits.
Occidental Petroleum has nearly doubled its price and is the best performer in the S&P 500. Exxon Mobil, Hess and Halliburton were also winners.
Wall Street’s most surprising aspect is the speed at which everything changed.
On January 5, a report from the Fed’s December meeting was published. These minutes revealed that Fed members saw rising inflation to be a major threat to the economy, and that they would need to raise rates sooner than anticipated.
Although the words were dry as they are often, the summary indicated a drastic shift in Fed’s stance. The market reacted quickly. The major stock market indexes all fell on that day, with Nasdaq losing the most aEUR” (more than 3%)
This was only the beginning. Over the next few months, Fed officials maintained their negative stance, while inflation numbers got worse. This combination created a spiral of pessimism in the markets.
The Fed has been aggressive in attempting to combat inflation which is at an all-time high of 40 years. The Fed has raised the benchmark interest rates three times this year. This is the largest increase since 1994.
Yung-Yu Ma is the chief investment strategist at BMO Wealth Management. He says that it was a fast-moving environment where inflation continues to surprise and the Fed’s projections about how quickly it would raise interest rates… continued to exceed expectations.”
These expectations were also drastically different from those of last year, when Fed Chair Jerome Powell as well as Treasury Secretary Janet Yellen appeared confident that inflation would fade aEUR”, meaning it would be a temporary consequence of the U.S. emerging out of the worst days of the pandemic.
We now know they both underestimated the inflation path and were slow in implementing changes. Yellen admitted that she misread the moment a few weeks back. CNN interviewed Yellen and said that she believed she was wrong about the direction inflation would take.
The Fed’s recent rate hikes are an indication of its catch-up efforts, but others fear it could signal the beginning of a new era with higher interest rates. After a decade of low monetary policy, this year’s rate rises may be a sign of the Fed trying to catch up. Others believe this will be necessary in order to manage higher inflation.
Gargi Chaudhuri of BlackRock’s iShares investment strategy says that inflation will rise for a longer time. “Maybe not 8.6% today, but still higher than the pre-pandemic levels.”
She isn’t one of the growing number portfolio managers who believe we will experience a recession within six months. She is like everyone else and pays close attention to economic data. This includes quarterly earnings reports from companies, as well as reports from the federal government on jobs and inflation.
The Federal Reserve administers tough medicine to the U.S. Economy and policymakers are well aware of the risks. The Fed’s interest rates could be too high to cool the economy, which could cause a severe downturn or even a recession.
That is something Powell acknowledges. On Wednesday, Powell said at an European Central Bank conference: “Is it a risk that we would go too far?” There is a risk.
Politicians and policymakers are eager to see immediate changes, but it will take time for everyone to see if the Fed is actually working.
Markets will stabilize if there is any indication that the Fed is bringing down inflation within the next few months. If the Fed fails to control inflation, then all bets are off.
