Why is the stock market this year such a disaster? The answer is very simple: interest rates! This year’s bear market is almost entirely due to the Federal Reserve’s response to the highest inflation in 41 years: Sharply rising rates!
Near zero interest rates caused a boom in the housing market, made it cheaper for consumers, businesses and governments to spend, made bonds and cash unattractive relative to equities and were rocket fuel for the stock market over the last 13 years.
But now interest rates are sharply higher. And 3 policy errors made by governments worldwide are to blame:
1. Shutting down the global economy in response to the spread of COVID-19
2. Blowout government spending.
3. Decision last year by central banks to let inflation run well above its 2% price target.
The result was that inflation run away and got out of control. Central Banks had had to take severe steps by raising interest rates in 3/4-point increments, the fastest pace in more than 30 years.
The reason central banks generally raise rates a 1/4 point at a time is to have the chance to pause and monitor the consequences of the rate hike.
Instead, the central banks are now very busy in putting out the fire it started. Probably going too far and therefore pushing the economy into a recession.
These 3 policy failures – lockdowns, excessive government spending and delayed tightening are the real culprits behind this year’s bear market.
And if the sell-off has felt different than earlier ones, that’s because it is. Over the past 40 years, when economic activity started to wane and the stock market faltered, the Fed generally stepped in to ease the pain by lowering rates. That will not happen this time.
The Federal Reserve has a dual mandate: full employment and low inflation. With unemployment near record lows and inflation unacceptably high, the central bank will take rates higher. The so-called “Fed put” serving as a support and floor for the stock market is gone for now, what could send stocks even much lower.
Are all these factors already widely recognized and priced into stocks? Markets tend to overshoot on the downside, just as they do on the upside.
That’s why stocks began a rally after better inflation numbers than expected. So, is there a genuine change in the market’s direction under way? May be, but there is still a high probability that stocks might go lower from here. Risky times for stock investors.
Sven Franssen