Stock markets off to worst start since 2016 as Fed battles inflation

After falling for the fourth day in a row on Friday, the stock market had its worst week in nearly two years, and so far in January the S&P 500 has had its worst start since 2016. Tech stocks have been particularly hard hit , with the Nasdaq composite index falling more than 10% from its most recent peak, which is seen as a correction in Wall Street discussions.

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

So far, markets have ignored these issues during the pandemic, which has driven sharp increases in the value of all kinds of assets.

Yet one crucial factor has changed, giving some market watchers reason to worry that the recent drop could have consequences. This element is the Federal Reserve.

As the worst economic ravages of the pandemic appear to be waning, at least for now, the Fed is ushering in a return to higher interest rates. He is also starting to withdraw some of the other forms of support that have allowed stocks to fly since he stepped in to save desperately hurt financial markets in early 2020.

That could be a good thing if it brings down inflation without derailing the economic recovery. But the removal of that support also inevitably chills markets as investors move money around, seeking outperforming assets when interest rates are high.

“The Fed’s policies basically started the current bull market,” said Edward Yardeni, an independent Wall Street economist. “I don’t think they’re going to shut it down now, but the environment is changing and the Fed is responsible for a lot of that.”

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

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

What happens next comes from an established playbook. As William McChesney Martin, a former Fed chairman, put it in 1955, the central bank finds itself playing the role of the adult in the play, “who ordered the removal of the punch bowl just when the party was really starting to heat up.”

Market sentiment changed on Jan. 5, Yardeni said, when Fed officials released minutes from their December policy-making meeting, revealing they were set to adopt a much stricter monetary policy. A week later, new data showed that inflation had reached its highest level in 40 years.

Putting the two together, it looked like the Fed would have no choice but to react to curb the rapid rise in prices. Stocks began a disorderly decline.

Financial markets now expect the Fed to raise its key rate at least three times this year and start shrinking its balance sheet this spring. It has already reduced the level of its bond purchases. Fed policymakers will meet next week to decide their next steps, and market strategists will be watching.

Low interest rates have made certain sectors particularly attractive, foremost among which are technology stocks. The S&P 500 information technology sector, which includes Apple and Microsoft, has risen 54% on an annualized basis since the pandemic-induced market low in March 2020. One reason for this is that rates Low interest rates magnify the value of expected future returns from growth-oriented companies like these. If rates rise, this calculation can change abruptly.

The very prospect of higher interest rates has made technology the worst performing sector in the S&P 500 this year. Since its peak at the end of December, it has fallen by more than 11%.

The top three performing sectors on the S&P at the start of 2022, on the other hand, are energy, financials and consumer staples.

The energy index is dominated by fossil fuel companies, like Exxon Mobil and Halliburton, whose fortunes have risen with oil and gas prices. Financial companies may charge higher loans when interest rates are high. Big banks like Wells Fargo have reported bumper profits over the past week. Consumer companies like Kraft Heinz and Campbell Soup lagged the explosive stock price growth of tech stocks at the start of the pandemic, but they have been gaining ground in this new environment.

The stock market as a whole also lost some momentum for reasons other than monetary policy. “Stay at home” stocks that have thrived during pandemic restrictions, like Netflix and Peloton, have started to falter as people venture out more.

Some savvy 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 “superbubble”.

But the current losses could be beneficial if they let some air out of a possible bubble, without bursting investors’ wallets. This year’s declines only erase a small portion of the market’s gains in recent years: the S&P 500 is up nearly 27% last year, more than 16% in 2020 and nearly 29% in 2019.

And the outlook for corporate earnings remains good. Once the Fed starts to act and the effects are better understood, the stock market party could continue – at a less dizzying pace.

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