Investors, it’s OK to feel overwhelmed right now.
Even for a year that has already presented investors with a lot to digest, the past couple of weeks in the markets have been ones for the record books. That’s the case whether you are a once-a-quarter portfolio checker or a Wall Street pro.
“We’ve seen wild gyrations and we’ll probably continue to see wild gyrations as the markets continue to digest this very, very significant change from the Fed,” Invesco's chief global market strategist Kristina Hooper says.
When it comes to staying focused on longer-term strategies and financial goals, “it’s so hard in this environment just given the level of volatility we’ve experienced,” Hooper says. “Perhaps 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 to sleep for a year.”
Take this week, where stocks jumped almost 3% Wednesday in a “relief rally” after the Federal Reserve raised interest rates . Then on Thursday shares plunged 3.7% as the markets “reconsidered” the Fed rate news of the previous day.
As of this writing on Friday afternoon, stocks were on track for another volatile day in the red, leaving the Morningstar US Market Index down roughly 14% this year. Technology stocks and shares of other fast-growing companies continue to get pummeled, and while less volatile consumer staple stocks, and shares in other value names are holding up better, much of the market is taking losses for the year.
Things aren't any better in the bond market, which is having one of its worst years in modern history. The yield on the widely followed U.S. Treasury 10-year note has jumped to over 3% from 0.93% at the end of last year. The yield on the Treasury two-year note, a key benchmark for short-term rates, has risen to 2.7% from 0.7%. That’s led to big losses across bond investments. The broad Morningstar US Core Bond Index is down north of 10% in 2022.
The results have investors feeling pain on both the stock and bond sides of their portfolios, an unusual occurrence. (Though it is worth noting that over the last three years, the Morningstar US Market Index is still up 45% in total and bonds are flat.)
While veteran market watchers are shaking their heads over swings across the markets, there is an underlying logic to these trends. It ties back to the rush that the Federal Reserve now finds itself in to raise interest rates.
While a yearlong nap certainly sounds like a good idea, for strategic-minded investors the good news is that in the stock market at least, valuations are looking a lot more reasonable, especially if it turns out the Fed doesn’t have to be more aggressive than the markets already expect.
Making sense of the market’s volatility starts with the surge in inflation and the resulting jump in interest rates. Prior to this year, the Consumer Price Index averaged 2.2% for the past 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 is now over. As a result, the market has had to adjust to inflation, which has jumped to over 8% on an annual basis.
There’s a rationale behind these moves. Coming into this year the Fed and financial markets were expecting an economy where last year’s inflation pressures would ease, and interest rates could rise at a measured pace. Only three rate hikes were expected for this year.
Here’s a look at how expectations have evolved for the June meeting of the policy-making Federal Open Market Committee. In late 2021, bond futures contracts were priced for the Fed to raise rates by a quarter or half a percent in the middle of 2022.
This past Wednesday, the Fed announced a 0.5-percentage-point increase in the federal-funds rate, the first increase of that size in 22 years. The funds rate target now stands at 0.75%, already ahead of where the markets expected it would be, and up from zero before the rate hikes began in March with a quarter-point increase.
For June, the bond market is now predicting the Fed will raise rates another three fourths of a percent. The Fed hasn't hiked the funds rate by that much in a single meeting since 1994. Those expectations are in place despite Federal Reserve Chair Jerome Powell telling financial markets to expect just half-point increases at both the June and July meetings.
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 matters far beyond the Fed’s control. There were and continue to be distortions to the global economy posed by the COVID-19 pandemic, such as the recent lockdowns of major Chinese cities. Russia’s attack on Ukraine added to global shipping woes, caused a spike in oil prices that has yet to fully reverse and threatens key aspects of global food supplies, all of which are feeding into inflation dynamics.
Making matters worse, the Fed’s policy stance into late 2021 was one still 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’s this uncertainty around the inflation outlook that, in the end, has been driving the uncertainty in the market.
For now, rapidly changing expectations for the Fed to move faster and further on rates are at the core of the selloff and volatility in the stock market. Rising interest rates aren’t necessarily a negative for stocks. When interest rates rise the economy is typically healthy, which is good news for corporate profits. While the goal of the Fed’s rate hikes is to slow growth and cap inflation, historically stocks have tended to move higher in the months after rate increases.
However, the transition from steady or falling rates to rising rates is where the air pockets can happen.
“If you look back to every business cycle going back to World War II, we have had one of these Fed-policy driven corrections--an uncertainty shock,” says Barry Knapp, director of research for Ironsides Macroeconomics.
That’s especially the case for stocks that were trading at high valuations, which was the case for many tech and consumer communications companies.
“At the start of the tightening cycle is when higher-valuation names come under pressure,” Hooper says.
Perhaps the most visible reflection of this is the performance of growth stocks, where much of the value perceived in those names is in their earnings potential many years down the road. Higher interest rates reduce the value of those future earnings.
The result has been an absolute pounding for growth stocks. The Morningstar US Growth Index is down 27% in 2022. Meanwhile, value stocks, which had lagged growth for years, are down less than 1%.
Particularly hard hit has been the megasize stocks that were driving much of the market’s gains in recent years. So far this year, Netflix NFLX has plunged 69%, Facebook parent Meta Platforms FB has fallen 38%, Amazon AMZN dropped 30%, and Microsoft MSFT is down 17%.
“Once you get to the point where the Fed starts normalizing policy, in every business cycle, that’s the point where valuations start to matter,” Knapp says. “Once that liquidity starts to drain out of the system, you have to decide, 'Am I paying reasonable price for this growth?'"
From here, however, there may be opportunities arising for investors in the stock market that have some dry powder in their portfolios.
David Sekera, Morningstar’s chief U.S. market strategist, thinks that at this stage the stock market is overreacting in terms of declines.
Based on valuations for U.S.-listed stocks covered by Morningstar’s equity analysts, the market is roughly 12% undervalued, he says. “It’s likely a good time to be adding exposure to the stock market and moving to an overweight position,” Sekera says. He still sees value stocks as a better option for now.
Even beaten-down tech stocks shouldn’t be overlooked, Invesco’s Hooper says.
“A lot of the secular growth names are ones that have wider profit margins, especially in many areas of tech,” she says. “Oftentimes, those that are beaten down the most in the rate-hike cycle are the ones that are best performer for the full cycle.”