Stocks tumbled in January, posting their largest monthly loss since the beginning of the pandemic. Investors were spooked by unabated inflation, ongoing supply chain issues and semiconductor shortages, and the buildup of Russian military forces around Ukraine. Investors felt threatened on many levels, and the markets reflected that.
The looming question is whether the Fed’s efforts to cool inflation will suffocate economic growth. Wall Street may have accepted that the days of cheap money are over but remains deeply worried about the timing and potential impacts of interest rate hikes.
Though officials at the Fed continued to express concern about inflation at their meeting in January, most members have attempted to soothe investors, pushing back on the idea that central bankers may raise interest rates between scheduled meetings. They also made it clear that even if rates rise in March, the initial increase may be smaller than what investors expect.
Fed reassurances offered scant comfort. Short-term US government bonds declined sharply in a selloff that gained momentum after release of data showing that in the 12 months through January, the CPI jumped 7.5%, the biggest year-over-year increase since 1982.
The price fall sent the yield on two-year treasury notes, which are highly sensitive to monetary policy expectations, soaring to 1.6%, up from 0.5% three months ago. The yield on the ten-year treasury increased to 2%, though the rise wasn't as steep as on the shorter end. The result has been a dramatic flattening of the yield curve, with the difference between the two and the ten-year yields shrinking to its narrowest point since April 2020.
Some see the flattening yield curve as a sign of a slowing economy. Contrarians even foresee a bond rally once the Fed's expected rate hikes hit a slowing economy. Though there is little evidence of that right now, corporate earnings are expected to slow this year after rising a projected 9% in the first quarter. Some analysts point to worrying signs in the data about US manufacturing. January saw the weakest rise in factory activity since October 2020, and new orders rose at the slowest pace since September 2020.
Equities sank on all the unsettling January news. The S&P 500 index fell 5.3%, its worst month since dropping 12.5% in March 2020 when the pandemic abruptly shut down the global economy. The Dow Jones industrial average and the Nasdaq composite also ended in the red for January, with the Dow shedding 3.3% and the Nasdaq losing 9%.
The month’s heaviest losses were concentrated in areas where stocks were perceived to be the most expensive. High-growth technology stocks, which were stars of the pandemic amid expectations that they will continue to grow regardless of economic conditions, took a nosedive. The tech sector ended the month down 6.9%, a much needed correction.
What comes next? The markets themselves offer clues about what we might expect. The break-even inflation rate, a predictive measurement of expected inflation, signals that the markets predict inflation of 2.5% to 3% over the next five years. This is far below the high rates we’ve recently witnessed.
It is impossible to know what will happen with inflation, but not impossible to plan ahead. Globally diversified stocks and bonds have had good returns in periods of high inflation and low inflation. Investors concerned about runaway inflation can hedge their risk with different asset categories, including TIPS, Swaps, Gold and other commodities. Of course, hedging carries its own risks, but the tools are there if one chooses to use them. As always, choosing one path over another requires clarity about one’s goals. The best defense may well be what it has always been: a well-diversified, risk-adjusted, goal-based portfolio.
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