Stocks relinquish gains, close lower on inflation and rate hike fears

Over the last few decades, investors’ time frames have shrunk. They’ve become obsessed with quarterly returns. In fact, technology now enables them to become distracted by returns on a daily basis, and even minute-by-minute. Thus, one way to gain an advantage is by ignoring the ‘noise’ created by the manic swings of others and focusing on the things that matter in the long-term. – Howard Marks

In yet another turbulent week for the stock market, the major averages all closed lower after the hotter than expected January consumer price index (CPI) was released on Thursday and concerns rose on Friday that Russia would invade Ukraine soon. It was a disappointing end to what had been a promising start to the week as fourth quarter earnings continue to be mostly better than expected. So far over 60% of S&P 500 companies have reported earnings and about 77% of them have topped earnings expectations while about 77% of them have beaten revenue estimates. Through Wednesday, the S&P 500 had risen about 2% on this good news as investors bought the dip after stock prices had declined to start the year. However, the CPI for January rose 7.5% year-over-year, which was higher than forecast and the biggest gain since February 1982. Core inflation, which excludes food and energy prices, also rose more than expected and prompted fears that the Federal Reserve might become more aggressive in fighting inflation, which could ultimately slow economic growth. As a result, the odds of a 50 basis point (a basis point is one hundredth of one percent) increase in the federal funds rate in March by the Federal Reserve increased substantially as did the probability of six rate hikes for the year. The yield on the 10-year Treasury also rose above 2%, the first time that it has been above this level since August 2019, while the yield on the 2-year Treasury topped 1.5% after starting the year at only 0.78%.  (Bond yields and prices are inversely related). Stocks dropped on this inflationary news and tumbled again on Friday after both the U.S. and the United Kingdom urged their citizens to leave Ukraine as soon as possible as an invasion by Russia appeared to be imminent. Comments by St. Louis Federal Reserve President James Bullard also unnerved investors as he called for the Fed to raise the federal funds rate by 50 basis points in March and a full point by the start of July. Although earnings have mostly surprised to the upside, geopolitical tensions, high inflation and rate hike fears have created a lot of uncertainty for investors. Until these issues are resolved or become clearer, the market is likely to remain on edge.

Last Week

Weekly jobless claims declined last week to 223,000, below the estimate of 230,000. The preliminary University of Michigan consumer sentiment index in February came in lower than in January and was less than expected as the outlook for inflation worsened.

For the week, the Dow Jones Industrial Average fell 1.0% to close at 34,738 while the S&P 500 Index lost 1.8% to close at 4,418. The Nasdaq Composite Index dropped 2.2% to close at 13,791.

This Week

The producer price index (PPI) for January is expected to increase over 9% year-over-year while the core PPI that excludes food and energy prices is expected to rise 8%. January retail sales are forecast to rebound strongly after declining in December while January leading economic indicators are forecast to increase about 1%, slightly better than in December. Both housing starts and existing home sales in January should be on a par with the numbers reported in December and consistent with a healthy housing market.

Minutes from the most recent Federal Reserve meeting will be released and investors will be looking for guidance on the Fed’s plan to raise interest rates.

The most notable companies that are scheduled to report quarterly earnings this week are Walmart, Deere, Devon Energy, Marathon Oil, Vulcan Materials, Consolidated Edison, Southern Company, Advance Auto Parts, Mariott International, Viacom-CBS, Airbnb, American International Group, Kraft Heinz, Analog Devices, Cisco Systems, Nvidia and Ecolab.

Portfolio Strategy

With the annual rate of inflation above 7% and showing no signs of abating any time soon, fixed income investors are faced with negative real returns as bond yields remain near historic lows despite their recent increase. As yields have risen across the yield curve since the beginning of the year, the value of bonds and bond funds has also fallen, resulting in negative returns for all maturities but particularly damaging for intermediate and longer-term issues. One strategy that serves as a hedge against rising prices and increased inflation is purchasing exchange-traded funds or ETFs that focus on dividends. Since 1950 dividend growth has exceeded the rate of inflation and given investors a positive real rate of return of about 2%. Dividend growth has increased about 5.5% annually during this time period compared to average annual inflation of  3.5%. ETFs that track a specific index also have low expense ratios. Generally, there are two main types of dividend ETFs: those that invest in companies that have above-average dividend yields and those that invest in companies that increase their dividends year after year. In the former category, two of the largest dividend-paying ETFs are the Vanguard High Dividend Yield ETF (VYM) and the iShares Core High Dividend ETF (HDV). The Vanguard ETF invests in companies that track the FTSE High Dividend Yield Index and has a current yield of about 2.8%. The iShares ETF attempts to replicate the Morningstar Dividend Yield Focus Index and has a current yield of about 3.4%. Three of the largest ETFs that invest in companies that consistently increase their dividends every year are the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), the Vanguard Dividend Appreciation ETF (VIG) and the SPDR S&P Dividend ETF (SDY). The ProShares ETF tracks the S&P 500 Dividend Aristocrats Index and yields about 2.0% while the Vanguard ETF attempts to replicate the S&P U.S. Dividend Growers Index and currently yields about 1.70%. The SPDR ETF combines both high dividend-paying stocks as well as stocks whose companies consistently increase their dividends and tracks the S&P High Yield Dividend Aristocrats Index. The current yield of this ETF is about 2.7%.