Stocks fall as Fed raises its inflation expectations

Risk and time are opposite sides of the same coin, for if there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field. – Peter L. Bernstein

After beginning the week at record highs, the S&P 500 Index and the Nasdaq Composite Index retreated with the S&P 500 turning in its worst performance since February. The Dow Jones Industrial Average, however, bore the brunt of the losses with a decline of 3.5%, its worst week since October 2020. While the Federal Open Market Committee (FOMC) left interest rates unchanged at near zero and made no changes to its $120 billion a month bond buying program of U.S. Treasury securities and mortgage-backed securities, it was what was said after its meeting that spooked the markets. The Fed raised its inflation expectations for the year and moved up the timeline on its next interest rate hike as early as 2023 with members expecting two rate hikes in that year. Federal Reserve Chairman Jerome Powell also said that the Fed will provide “advance notice” before announcing its plan to taper its asset purchases. It reiterated its view that the current inflation spike is transitory and will subside as supply and demand issues are resolved and that inflation will trend toward its 2% goal in the long run. The market’s reaction to the meeting was muted until Friday when St. Louis Federal Reserve President Jim Bullard said that the first interest rate hike could come as early as next year. Stocks tumbled after his comments and the yield curve flattened with the 2-year Treasury yield rising to 0.26% and the 10-year Treasury yield falling to 1.45%, a sign that investors have become less optimistic about economic growth. The rise in short-term bond yields reflected expectations by investors that the Fed will be raising interest rates, albeit a long way out in the future. As a result of Bullard’s remarks, those sectors of the market most sensitive to an economic recovery, namely energy, materials, financials and industrials, led the sell-off while sectors such as technology, health care and consumer staples fared much better. Although last week’s sell-off was painful, the S&P 500 Index remains only about 2% from its all-time high, but doubts about the strength of the economic recovery could lead to more volatility in the stock market in the months ahead.

Last Week

The producer price index (PPI) for May rose more than expected and was up 6.6% over the last 12 months, the biggest increase since the tracking of this piece of inflation data began in November 2010. Retail sales in May dropped more than expected but April sales were revised appreciably higher. Weekly jobless claims rose to 412,000, higher than expected and up from 375,000 the previous week.

For the week, the Dow Jones Industrial Average plunged 3.5% to close at 33,290 while the S&P 500 Index dropped 1.9% to close at 4,166. The Nasdaq Composite Index lost 0.3% to close at 14,030.

This Week

Durable goods orders for May are expected to show a big increase after declining in April while the final first quarter gross domestic product (GDP) estimate is expected to remain at 6.4%. May existing home sales are forecast to fall slightly from levels in April while May new home sales are forecast to exceed the numbers reported in April. Existing home sales have fallen for three straight months as demand has outstripped supply.

The most notable companies that are scheduled to report quarterly earnings this week are Steelcase, Winnebago Industries, Darden Restaurants, FedEx, Nike, Rite Aid, Car Max and Paychex.

Portfolio Strategy

The Federal Reserve’s realization last week that inflation is running hotter than it expected caused it to reevaluate its monetary policy and could mean higher interest rates sooner rather than later. With volatility likely to increase in the stock market and prices likely to continue their upward trend over the near-term, investors can play defense by investing in companies that have a history of increasing their dividends or paying an above-average dividend. Many companies have the ability to increase their dividends faster than the rate of inflation which makes them a good hedge against rising prices. Relative to higher priced growth stocks, stocks with above-average dividend yields or so-called value stocks are also far cheaper on a valuation basis. The high dividend yields provide investors with some downside protection in the event of a market sell-off.  There are several exchange-traded funds or ETFs that invest in companies that have a long history of increasing their dividends as well as providing investors with relatively high dividend yields. The ProShares S&P 500 Dividend Aristocrats ETF (NOBL) tracks the performance of the S&P 500 Dividend Aristocrats Index and invests in high quality companies that have grown their dividends for at least 25 years. These companies have solid fundamentals and strong histories of profit and growth. The current yield of this ETF is about 1.9%, higher than the current yield of 1.45% on the 10-year Treasury. The Vanguard Dividend Appreciation ETF (VIG) is another such fund that tracks the performance of the Nasdaq U.S. Dividend Achievers Select Index, which invests in companies with a record of growing their dividends year over year. It has a current yield of 1.7%. For funds with above-average dividend yields, the Vanguard High Dividend Yield ETF (VYM) tracks the performance of the FTSE High Dividend Yield Index and invests in large cap domestic stocks that pay relatively high dividends. Its current yield is about 2.7%. Finally, the iShares Core High Dividend ETF (HDV) tracks the performance of the Morningstar Dividend Yield Index and yields 3.3%. All of these ETFs have relatively low expense ratios and higher yields than that of the S&P 500 Index, making them a solid defensive choice in an inflationary environment.