Markets Get a Reality Check From the Fed

Key Takeaways

• The good news with the Consumer Price Index was that for the second-straight month, the report came in softer than expected.
• The Federal Reserve increased its benchmark borrowing rate by half a percentage point, less than the four previous hikes, which could be a good environment for bonds.
• Before this year, one of the best places for investors to be were these big mega-cap technology companies, like Apple AAPL and Microsoft MSFT. Now, they have become some of the worst.
• We’ve seen the past few weeks that the strong dollar in 2022 is starting to weaken.

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Ivanna Hampton: The highly anticipated news about inflation and interest rates dropped this week. The November Consumer Price Index showed inflation remains high, but it rose smaller than expected. The Fed increased its benchmark borrowing rate by half a percentage point, less than the four previous hikes. Morningstar’s markets team has tracked the developments this week, and joining me now is Morningstar Inc’s chief markets editor and Smart Investor newsletter editor, Tom Lauricella. Tom, it’s good to see you.

Tom Lauricella: Good to be here.

Hampton: Let’s start with the November Consumer Price Index report. What’s the good news there?

Lauricella: The good news with the CPI was that for the second-straight month, the report came in softer than expected. This has confirmed people’s thinking that we’ve seen the peak of inflation. We had inflation running at its highest levels in four decades. There’s some good news there that at least for now, inflation has turned lower, and the question going forward is really, how much further will it fall? There was also some good news on that front in the report, but the outlook is still a little bit unclear.

Hampton: The Fed Chair Jerome Powell spoke about the Fed’s fight against inflation. How does his view on interest rates compare to the stock market’s view?

Lauricella: This is a really interesting situation that we have going, which is that the stock market in particular has been behaving as if the Fed was going to be able to start lowering interest rates next year, that inflation would be down close to the Fed’s target, and that we also wouldn’t have much of a recession, if one at all, and that everything was going to be fine. Powell was saying something completely different. He was speaking in a very hawkish, anti-inflation tone, saying basically that it’s unclear whether they’ve won the battle against inflation, and that the Fed is going to keep fighting and keep rates high until that they’re sure that inflation is really dead.

There’s a little bit of a difference between what the market has been expecting, what Powell said, and that helped to account for the selloff that we’ve seen in the stock market the last few days, as investors began to rethink this Goldilocks kind of outlook.

Hampton: An article appearing in this week’s Smart Investor newsletter has the headline “Why the Fed May Yo-Yo With Interest Rates.” Tom, why could that be the case?

Lauricella: This is another interesting aspect. What may or may not happen next year, Fed policies, the outlook is very confused right now. We spoke to one of the strategists at Bank of America, and the idea there is that as we get into 2023, that there’s a very good chance of a recession, and that the Fed would likely respond to that recession by lowering rates.

However, they may end up lowering rates before they’ve won the battle against inflation, which could mean that the Fed would lower rates, and then discover that inflation is starting to rise back up and have to raise interest rates again. You kind of have that yo-yo effect in Fed policy. Yet another outcome that the market isn’t really looking at.

Hampton: Big losses mounted for Big Tech this year. Why did Big Tech have such a brutal year?

Lauricella: This was one of the big stories for 2022 as we start to wrap up the year. Prior to this year, one of the best places for investors to be were these big mega-cap technology companies, like Apple, Microsoft. This year, it was the opposite. They were among the worst places to be. Many of these stocks, household name companies, have done much, much worse than the overall market. We’ve got Facebook’s parent company Meta Platforms META down 66% this year, 66%. Semiconductor manufacturer Nvidia NVDA, which was up triple digits in 2021 is down 42%.

Really, the story was the rise in interest rates, very optimistic expectations for these companies that just clashed with the reality of what was happening out there in the economy. The net result is that some $4 trillion of market capitalization was wiped out of just the six biggest tech stocks this year. It’s quite a story for 2022.

Hampton: Let’s shift to 2023. Morningstar has released its bond market outlook. What are the risk and opportunities for investors?

Lauricella: Yes. Dave Sekera, our strategist, outlined his outlook for the bond market this week. The idea is that the bulk of the interest-rate increases from the Fed are behind us. We’ll still have some more of that in the early part of the year, but the Morningstar house view is that inflation is going to be coming down, enough that it could be a good environment for bonds. It kind of depends on the types of bonds that you’re investing in and what time of year we’re talking about.

In general, intermediate-term bonds, bond funds might be the best place to be early on. The good thing right now is you’re earning quite a nice yield on these bonds. Safe government bonds are yielding very attractive levels. Then as we get further into the year, if the Morningstar forecast plays out and inflation comes down, the Fed can ease, and longer-term bonds will be the place to be. Then it depends on what happens in terms of the economy for corporate bonds. If the economy does avoid a significant recession as Morningstar expects, it’ll be bumpy for corporate bonds. Overall, should be a good place to be the second half of the year.

Hampton: Your markets team has written about the U.S. dollar and the surge this year. What could lead to a weak dollar next year?

Lauricella: This is another potential change for 2023 versus 2022. One of the big stories in the markets in 2022 was the strength of the dollar. The dollar had its biggest rally in some 20 years against other currencies. This was really driven by the Fed’s rate increases. We’ve seen the last few weeks that the dollar is starting to turn and weaken. Really, this is about expectations for the Fed beginning to lower rates next year.

The catch here is that if the dollar does begin to decline, it’s actually not good for inflation because it raises the price of commodities. Again, we could have this very sort of uncertain, unstable outlook, where we’ve got a lot of moving parts next year. Some of these trends that could take place might not actually be so favorable for the markets.

Hampton: What are the pros and cons of weak dollar?

Lauricella: Well, the strong dollar has helped on the inflation front this year. Despite all the bad news that we had on inflation, it could have been worse actually if the dollar had been going the other direction. As I said, the main thing here is that a weaker dollar kind of imports inflation into the economy, and that could make the Fed’s job a lot tougher and keep markets volatile and on their toes through much of next year.

Hampton: Well, thanks, Tom, for giving us a preview of this week’s Smart Investor newsletter.

Lauricella: Glad to be here. Thanks.

Hampton: Subscribe to Smart Investor newsletter. You can catch up on the weekly rundown of Morningstar’s latest on big market trends and investment opportunities. I’m Ivanna Hampton, a senior multimedia editor at Morningstar.