Investors, it’s okay to feel overwhelmed right now.
Even during a year that has already presented investors with much to digest, the last two weeks in the markets have been for the record books. That’s the case whether you’re a once-a-quarter portfolio checker or a Wall Street pro.
“We have seen wild swings and will likely continue to see wild swings as markets continue to digest this very, very significant change from the Fed,” Invesco said. chief global market strategist Kristina Hooper says.
When it comes to staying focused on long-term strategies and financial goals, “it’s very difficult in this environment given the level of volatility we’ve experienced,” says Hooper. “Maybe it would have been better to take a Rip Van Winkle approach to investing this year: Make sure you’re well-diversified based on long-term goals and go sleep for a year.”
Take this week as an example, where stocks rose nearly 3% on Wednesday in a “relief rally” after the Federal Reserve raised interest rates. Then on Thursday, stocks fell 3.7% as markets “reconsidered” the previous day’s Fed rate news.
As of this writing Friday afternoon, stocks were on course for another volatile day in the red, leaving Morningstar’s US market index down about 14% this year. Technology stocks and stocks of other fast-growing companies continue to take a beating, and while less volatile consumer staples stocks and stocks in other value names are holding up better, much of the market is taking losses for the year.
Things are no better in the bond market, which is going through one of its worst years in modern history. The yield on the widely followed 10-year US Treasury note has jumped to more than 3% from 0.93% at the end of last year. The yield on the 2-year Treasury note, a key benchmark for short-term rates, has risen from 0.7% to 2.7%. That has led to big losses in bond investments. The broad Morningstar US Core Bond Index is down 10% in 2022.
The results have investors feeling pain.on both the stock and bond sides of their portfolios, an unusual development. (Though it’s worth noting that over the past three years, Morningstar’s US market index is still up 45% overall and bonds are flat.)
While veteran market watchers shake their heads at swings in the markets, there is an underlying logic to these trends. It relates to the rush the Federal Reserve is now in to raise interest rates.
While a yearlong nap certainly sounds like a good idea, for strategically minded investors, the good news is that, at least in the stock market, valuations look much more reasonable, especially if it turns out that the Fed isn’t you have to do it. be more aggressive than the markets already expect.
Making sense of market volatility starts with the rise in inflation and the resulting jump in interest rates. Before this year, the Consumer Price Index averaged 2.2% over the last 20 years. The biggest jump in inflation during the period was last year’s annual increase of 4.7%.
That led to a long period of relatively low interest rates. That’s over. As a result, the market has had to adjust to inflation which has jumped to over 8% a year.
There is a reason behind these moves. Entering this year, the Federal Reserve and financial markets were expecting an economy in which last year’s inflationary pressures would ease and interest rates could rise at a modest pace. Only three rate hikes were expected this year.
Here’s a look at how expectations have evolved for the June meeting of the Federal Open Market Committee charged with policymaking. At the end of 2021, bond futures contracts were priced for the Fed to raise rates by a quarter to a half percent in mid-2022.
Last Wednesday, the Fed announced a 0.5 percentage point increase in the fed funds rate, the first increase of that size in 22 years. The funds rate target now sits at 0.75%, already above where markets had expected it to be, and above zero before rate hikes began in March with a quarter-point increase.
For June, the bond market is now predicting that the Fed will raise rates another three-quarters of a percent. The Fed hasn’t raised the funds rate that much at a single meeting since 1994. Those expectations are in place despite Federal Reserve Chairman Jerome Powell telling financial markets to expect hikes of just half a point at the meetings. of June and July.
While there is always a level of uncertainty when it comes to what the Fed will do with monetary policy, the current environment is especially complicated by issues beyond the Fed’s control. There were and continue to be distortions in the global economy posed by the COVID-19 pandemic, such as the recent lockdowns of major Chinese cities. Russia’s attack on Ukraine has added to global shipping problems, caused a surge in oil prices that has yet to be fully reversed, and threatens key aspects of global food supplies, all of which are fueling the dynamics of inflation.
To make matters worse, the Fed’s policy stance through the end of 2021 remained focused on providing fuel for economic growth through a combination of a zero funds rate and bond purchases that kept bond yields artificially low.
It is this uncertainty around the inflation outlook that, in the end, has been driving uncertainty in the market.
For now, rapidly changing expectations that the Fed will move faster and further on rates are at the core of the sell-off and volatility in the stock market. Rising interest rates are not necessarily negative for stocks. When interest rates go up, the economy is usually healthy, which is good news for corporate profits. While the goal of Fed rate hikes is to slow growth and limit inflation, stocks have historically tended to rise in the months following rate hikes.
However, the transition from constant or decreasing rates to increasing rates is where air pockets can occur.
“If you look back at every business cycle going back to World War II, we’ve had one of these Fed policy-driven corrections: an uncertainty shock,” says Barry Knapp, research director at Ironsides Macroeconomics.
That’s especially the case for stocks that were trading at high valuations, as was the case with many technology and consumer communications companies.
“Early in the tightening cycle is when the higher-valued names come under pressure,” says Hooper.
Perhaps the most visible reflection of this is the performance of growth stocks, where much of the perceived value in those names is in their earnings potential many years from now. Higher interest rates reduce the value of those future earnings.
The result has been an outright blow to growth stocks. Morningstar’s US Growth Index is down 27% in 2022. Meanwhile, value stocks, which had lagged behind growth for years, are down less than 1%.
Particularly hard hit have been large stocks that have been driving much of the market’s gains in recent years. So far this year Netflix (NFLX) it has collapsed 69%, Facebook’s parent metaplatforms (FULL BOARD) has fallen by 38%, Amazon (AMZN) fell 30% and Microsoft (MSFT) is down 17%.
“Once you get to the point where the Fed starts to normalize policy, every business cycle, that’s the point where valuations start to matter,” says Knapp. “Once the liquidity starts to drain from the system, you have to decide, ‘Am I paying a reasonable price for this growth?’”
From here, however, opportunities may arise for stock investors with some dry powder in their portfolios.
David Sekera, chief US market strategist at Morningstar, believes that at this stage the stock market is overreacting in terms of declines.
Based on valuations of US-traded stocks covered by Morningstar stock analysts, the market is roughly 12% undervalued, he says. “It’s probably a good time to add exposure to the stock market and move to an overweight position,” says Sekera. She still sees value stocks as a better option for now.
Even battered tech stocks shouldn’t be overlooked, Invesco’s Hooper says.
“A lot of the secular growth names are the ones with the widest profit margins, especially in many areas of technology,” he says. “Often those who are hit the hardest in the rate hike cycle are the ones that perform the best throughout the cycle.”