The economy is slowing, but major economists predict that it will still grow a robust 4% this year. The U.S. is near full employment and wages are rising.
So why the sudden change in the tone of the market? The answer can be found in inflation, interest rates and valuations.
1.) Inflation
Inflation has been historically mild for most of the last four decades. But producer prices are now rising at a 10% annual rate and consumer prices at 7%, the highest level since 1982. Inflation is partly due to supply chain issues. But there are other factors behind the big increase.
In response to the pandemic-related recession of 2020, the sharpest in U.S. history, the government spend massively. As a result of this enormous deficit spending, the ratio of debt to gross domestic product ballooned to 136%, a record. The Federal Reserve supported this action by buying up much of the newly issued debt to suppress yields. M2 money supply skyrocket from $15 trillion in 2020 to $21 trillion by last November. Yet, amazingly, the central bank still has short-term rates at zero and is buying billions of dollars of Treasury’s and mortgage-backed securities every month.
2.) Interest Rates
The Fed is set to raise short-term rates and taper its bond-buying program. Higher interest rates are negative for the stock market.
Investors have generally bet on the central bank to support financial markets by cutting interest rates if necessary to protect them from serious downturns. But this should be over. The Fed is behind the curve and has to hike rates. That is what makes investors nervous.
3.) Valuations
Growth stocks have been hammered. Value stocks have held up fine or even appreciated. There is a long overdue revaluation of risk underway. There is a switch from higher risk growth stocks to out of favour value stocks. Finally, value stocks get the attention they deserve. Expect this trend and also market volatility to continue.
Market volatility like we have experienced lately is the historical norm. Expect a lot more of this. The central bank will raise rates because the economic expansion is durable, corporate and household balance sheets are strong, and the pandemic is about to wane. That is positive for sales, earnings and share prices.
Sven Franssen