Inventory Markets Off to Worst Begin Since 2016 as Fed Fights Inflation

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After falling for the fourth straight day on Friday, the stock market endured its worst week in nearly two years, and in January the S&P 500 had its worst start since 2016. Technology stocks were hit particularly hard, with the Nasdaq Composite Index falling more than 10 percent from its recent high, which qualifies as a correction in Wall Street talks.

That’s not all. The bond market is also in turmoil, with interest rates rising sharply and bond prices falling moving in the opposite direction. Inflation is scorching hot and supply chain disruptions continue.

So far, during the pandemic, markets have overlooked such problems, which have brought large increases in the value of all types of assets.

But one key factor has changed, leading some market watchers to worry that the recent decline could have consequences. This element is the Federal Reserve.

As the worst of the economic devastation of the pandemic appears to be abating, at least for now, the Fed is beginning a return to higher interest rates. It is also beginning to withdraw some of the other forms of support that have kept stock prices buoyant since it intervened in early 2020 to bail out badly battered financial markets.

This could be a good thing if it beats inflation without derailing the economic recovery. But the removal of that support also inevitably cools markets as investors move money and look for assets that perform better when interest rates are high.

“Fed policy basically started the current bull market,” said Edward Yardeni, an independent Wall Street economist. “I don’t think they’re going to end everything now, but the environment is changing and the Fed is responsible for a lot.”

The central bank is tightening monetary policy partly because it worked. It helped spur economic growth by keeping short-term interest rates near zero and pumping trillions of dollars into the economy.

This flood of easy money also contributed to the rapid rise in prices of commodities like food and energy, as well as financial assets like stocks, bonds, houses and even cryptocurrencies.

What happens next is taken from an established playbook. As William McChesney Martin, a former Fed chairman, put it in 1955, the Fed finds itself as the adult in the room “who ordered the punch bowl removed just as the party was getting really heated.”

Market sentiment turned on January 5, Mr Yardeni said, as Fed officials released minutes from their December meeting, revealing they were on the verge of introducing much tighter monetary policy. A week later, new data showed that inflation had climbed to its highest level in 40 years.

Putting the two together, it seemed like the Fed had no choice but to react to curb rapidly rising prices. Stocks began a disorderly decline.

Financial markets are now expecting the Fed to raise interest rates at least three times this year and to start trimming its balance sheet as early as this spring. It has already reduced the level of its bond purchases. Fed policymakers will meet next week to decide their next moves, and market strategists will look on.

Low interest rates made certain sectors particularly attractive, most notably technology stocks. The information technology sector of the S&P 500, which includes Apple and Microsoft, is up 54 percent on a yearly basis since the market’s pandemic-related bottom in March 2020. One reason is that low interest rates reinforce the value of expected future returns for growth-oriented companies like this one. If interest rates rise, this calculation can change suddenly.

Frequently asked questions about inflation

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What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar won’t go as far tomorrow as it did today. It is usually expressed as the annual change in the price of essential goods and services such as groceries, furniture, clothing, transportation and toys.

What Causes Inflation? This may be the result of increasing consumer demand. However, inflation can also rise and fall on developments that have little to do with economic conditions, such as E.g. limited oil production and problems in the supply chain.

Is inflation bad? It depends on the circumstances. Rapid price increases mean problems, but moderate price increases could also lead to higher wages and job growth.

Can inflation affect the stock market? Rapid inflation usually spells trouble for stocks. Financial assets in general have historically performed poorly during inflationary booms, while tangible assets like houses have held up better.

The prospect of higher interest rates alone has made technology the worst-performing sector in the S&P 500 this year. It has fallen more than 11 percent since its peak in late December.

In contrast, the three best-performing sectors for the S&P in the early days of 2022 are energy, financial services and consumer staples.

The energy index is dominated by fossil fuel companies like Exxon Mobil and Halliburton, whose fortunes have risen along with oil and gas prices. Financial firms can charge more for loans when interest rates are high. Big banks like Wells Fargo reported record profits last week. Consumer companies like Kraft Heinz and Campbell Soup lagged the explosive price gains of tech stocks early in the pandemic, but they’ve gained ground in this new environment.

For reasons other than monetary policy, the stock market as a whole has lost momentum. Stay-at-home stocks that have thrived during the pandemic restrictions, like Netflix and Peloton, have started to falter as more people get out and about.

Some astute market analysts foresee bigger problems. Jeremy Grantham, one of the founders of GMO, an asset manager, predicts a catastrophic end to what he calls a “super bubble.”

But the current losses could be beneficial in venting a little air from a potential bubble without bursting investors’ portfolios. This year’s declines erase only a small portion of the market’s gains in recent years: The S&P 500 is up nearly 27 percent over the past year, more than 16 percent in 2020, and nearly 29 percent in 2019.

And the outlook for corporate earnings remains good. Once the Fed begins to act and the implications are better understood, the stock market party could resume — at a less dizzying pace.