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It was the worst start to the year for stocks in more than half a century.
The record run, fueled by cheap money, is over, and Wall Street is struggling to adjust to the new reality. As the Federal Reserve aggressively raises interest rates to fight high inflation, the economic landscape has changed dramatically.
As of mid-2022, the Nasdaq Tech Index is down nearly 30% and the broad-based S&P 500 index is down about 20% in the first six months of the year. Both indices are in bear market territory, while the Dow Jones Industrial Average is in correction. Since the beginning of the year, it has decreased by about 15%.
“When interest rates go up, the whole math changes,” says Charles Bobrinsky, vice chairman of Ariel Investments. “It changes the math of buying a car, buying a house, buying a bond, and changes the value of especially technology stocks that are far into the future.”
Which means that all of these Wall Street surges over the past few months, including massive one-day swings of over 1,000 points, reflect real investor nervousness. They are concerned that the Fed could trigger a recession in the US economy.
While this volatility was driven mainly by rising interest rates and inflation, it has been exacerbated by multiple geopolitical risks: COVID-19 continues to wreak havoc and lockdowns in China, global supply chains remain blocked, and Russian incursion into Ukraine continues.
Stocks with high growth rates fell first
Historically, when interest rates rise and borrowing costs rise, investors pull money out of the riskier sectors of the economy. High-growth companies and technology stocks are the first to fall.
This time is no different. The worst stock in the S&P 500 to date is Netflix, which is down 70%. It’s an incredible turn for a company whose stock price has skyrocketed during the pandemic, with the streaming service becoming a lifeline for the blocked. The second worst result is Etsy, an online marketplace for arts and crafts from artisans, which fell almost 65%.
There is one bright spot
Indeed, the only bright spot in stocks was energy. Russia’s invasion of Ukraine has pushed up oil and natural gas prices, while gasoline and diesel prices have set new records. This rise in commodity prices has benefited the world’s energy giants. Many of them have made record profits.
So far, the best performer in the S&P 500 this year has been Occidental Petroleum, which nearly doubled in value. Valero Energy returned 41%, Exxon Mobil, Hess and Halliburton were also winners.
It all started on one fateful day in January
Perhaps what struck Wall Street the most was how quickly things changed.
The first signal came on January 5, when the minutes of the Fed meeting held at the end of last year were published. These minutes showed that Fed members see rising inflation as a serious risk to the economy, and they will have to start raising rates earlier than expected.
The words were dry, as is often the case, but the summary signaled a sharp negative change in the Fed’s position. The reaction in the markets was fast. On this day, all major stock indices fell, most of all – Nasdaq – by more than 3%.
From there it only got worse.
This was just the beginning. Fed officials continued to reaffirm their negative stance over the next few weeks and months, inflation readings worsened, and this combination sent a wave of pessimism into the markets.
To combat inflation, which reached a 40-year high, the Fed acted aggressively. It has raised its benchmark interest rate three times this year, including once earlier this month by three-quarters of a percentage point, the biggest increase since 1994.
Yung-Yu Ma, chief investment strategist at BMO Wealth Management, says it was “a very fast-paced environment where inflation continued to surprise with its rise and the Fed’s own projections of how fast it was going to raise interest rates…continued to outperform expectations.”
The Fed initially underestimated inflation, and now it’s playing catch-up
Those expectations were also starkly different from last year, when both Fed Chairman Jerome Powell and Treasury Secretary Janet Yellen seemed confident that inflation would subside — that it would be a short-lived consequence of the U.S. coming out of the darkest days of the pandemic.
We now know that they both underestimated the path of inflation and were slow to act. A few weeks ago, Yellen admitted that she misinterpreted the moment. “I think I was wrong then about the path inflation would take,” she told CNN.
The sharp rate hike this year is a reflection of the Fed playing catch-up, but some fear it also signals the start of a new era of higher interest rates after more than a decade of loose monetary policy. Some believe that this will be necessary to cope with higher inflation in the future.
“Inflation will be higher for a longer period of time,” says Gargi Chaudhury, head of investment strategy for iShares at BlackRock. “Maybe not today’s 8.6%, but still well above pre-pandemic levels.”
She is not one of the growing number of portfolio managers who think we will see a recession in the next six months. Like everyone else, she keeps a close eye on economic data. This includes federal government jobs and inflation reports, as well as company quarterly earnings.
But will the Fed be able to beat inflation, or will its actions lead to a recession?
The Federal Reserve is administering a tough drug to the US economy, and politicians are aware that there are risks. If the Fed’s interest rate hike cools the economy too much, it could lead to a deep recession and even a recession.
Even Powell doesn’t discount it. Speaking at a conference of the European Central Bank on Wednesday, he said: “Is there a risk that we will go too far? Of course, there is a risk.”
There is great desire, especially among politicians, to see change immediately, but to everyone’s dismay, it will take time to see if the Fed’s cure works.
If in a few months there are signs that the Fed will be able to bring inflation under control, the markets will stabilize. But if it becomes clear that the Fed is not coping with inflation, all bets are off.
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