There are two times in a man’s life when he should not speculate – when he can’t afford it and when he can. – Mark Twain
For the second straight week to start the new year, stocks closed lower as fears mounted that the Federal Reserve will begin to fight inflation aggressively with interest rate hikes as well as a reduction in its bloated balance sheet. This past week it was the Dow Jones Industrial Average that bore the brunt of the selling with a loss of nearly 1% while the S&P 500 Index and the Nasdaq Composite Index finished with only modest losses. In his confirmation testimony before Congress last week, Federal Reserve Chairman Jerome Powell said that if the pace of price increases doesn’t slow, the Fed will be forced to raise rates and even worse begin to sell securities on its balance sheet. Some investment firms such as Goldman Sachs forecast four interest rate hikes in 2022 with the federal funds rate 100 basis points (a basis point is one hundredth of one percent) higher by the end of the year. Powell emphasized that the economy is both healthy enough to handle a change in policy and in need of a return to more normal monetary policy. Reasons cited by Fed Chairman Powell included falling unemployment, higher wages and hotter than expected inflation that appears to be more permanent than first thought. The last concern became evident the next day when the consumer price index (CPI) in December jumped 7% from a year ago, the fastest pace since June 1982. The core CPI, which excludes volatile food and energy prices, was up 5.5% year-over-year, the biggest increase since February 1991. Fourth quarter earnings season also got off to a rocky start as the big money center banks and investment firms posted disappointing results. JP Morgan Chase, the biggest U.S. bank in terms of assets, beat profit and revenue estimates but warned that the company would likely miss its earnings target in the next two years. Citigroup beat revenue estimates but its profit declined while Blackrock topped earnings expectations but missed slightly on revenue. Larger than expected expense growth was also evident and a worrisome sign going forward.
The December producer price index (PPI) was less than expected for the month but was up nearly 10% year-over-year, the highest it’s been in over ten years. Retail sales in December were also disappointing as they fell nearly 2%, much worse than expected. Weekly jobless claims were 230,000, compared to 200,000 that were forecast, while the preliminary University of Michigan consumer sentiment index in January was lower than expected due to higher than expected inflation.
For the week, the Dow Jones Industrial Average fell 0.9% to close at 35,911 while the S&P 500 Index declined 0.3% to close at 4,662. The Nasdaq Composite Index also lost 0.3% to close at 14,893.
Leading economic indicators for December are expected to increase nearly 1%, slightly less than in November. The Conference Board has forecast gross domestic product (GDP) to grow 6% in the fourth quarter 2021 and 3.5% for the full year in 2022. Both December housing starts and existing home sales are expected to be slightly less than in the previous month.
The Bank of Japan (BOJ) is expected to keep its key benchmark short-term interest rate unchanged at negative 0.1%. Unlike the Federal Reserve, both the BOJ and the European Central Bank (ECB) have stated that they don’t intend to raise interest rates this year.
The most notable companies that are scheduled to report quarterly earnings this week are Goldman Sachs, Morgan Stanley, Bank of America, U.S. Bancorp, Charles Schwab, PNC Financial Services, Northern Trust, Travelers, Bank of New York Mellon, Procter & Gamble, Netflix, UnitedHealth Group, CSX, Union Pacific, Baker Hughes, Schlumberger and United Airlines.
The focus this week will be squarely on fourth quarter earnings and will include a more diverse set of companies in other industry groups other than financials. Although profit results for the banks last Friday were mostly better than expected, expense growth was a concern and earnings guidance was clouded by inflation and rising wages. As a result, the bank stocks traded lower after running up prior to their earnings releases on the belief that higher interest rates would help their profit margins. Earnings for S&P 500 companies are expected to grow nearly 22% for the fourth quarter, marking the fourth consecutive quarter above 20%. Many portfolio strategists expect that earnings in cyclical sectors such as energy, materials, industrials and consumer discretionary will post stronger earnings growth than technology companies, which are forecast to grow earnings at about 10%. For this reason, value stocks that are characterized as those with lower price earnings ratios and higher dividend yields should outperform growth or technology stocks, which typically have higher price earnings ratios and much lower dividend yields. Technology stocks are also more vulnerable in a rising interest rate environment as the present value of their future earnings is worth less. Last week the 10-year Treasury yield ended the week at 1.78% after starting the year at 1.52%, an increase of 26 basis points (a basis point is one hundredth of one percent) in two weeks. While the Federal Reserve is in a quiet period this week ahead of their meeting on January 25th and there is no more inflation data, the direction of the 10-year Treasury yield could influence how stocks perform this week.