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Higher interest rates and a hawkish Fed sink stocks

Stock market corrections, although painful at the time, are actually a very healthy part of the whole mechanism, because there are always speculative excesses that develop, particularly during a long bull market. – Ron Chernow

Although first quarter corporate earnings continued to be mostly better than expected last week, the stock market didn’t seem to care as the major averages all suffered losses ranging from nearly 2% for the Dow Jones Industrial Average to almost 4% for the Nasdaq Composite Index. Granted, only about 15% of S&P 500 companies have reported their earnings results, but 80% of them have beaten analyst estimates, including such blue chip companies as IBM, Procter & Gamble, Tesla and Johnson & Johnson last week, just to name a few. However, it was the earnings report from Netflix that was the biggest surprise as the company lost 200,000 subscribers during the quarter, the first time it has lost subscribers in more than 10 years. The stock fell 35% after the announcement and the company expects more subscription losses in the future. The downbeat report and forecast affected the technology-heavy Nasdaq to a greater extent as these stocks tend to be richly valued growth stocks that trade at high price earnings multiples. Despite the positive sentiment around earnings season, the biggest negative for stocks continued to be the more aggressive tightening policy of the Federal Reserve aimed at reducing high inflation. Although much of the Fed’s anticipated interest rate hikes have already been priced into bond yields across the yield curve, no one knows for certain when inflation will come down. At the International Monetary Fund Debate on the Global Economy last week, Federal Reserve Chairman Jerome Powell said the Fed would move quickly to raise interest rates and doesn’t rule out a 50 basis point (a basis point is one hundredth of one percent) hike in May. But he also said that while rate hikes are needed, the Fed doesn’t want to risk halting the current economic expansion. In response to the Fed’s more aggressive policies, the yield on the 10-year Treasury has risen to 2.91%, the highest level since late 2018, from just 1.71% at the beginning of March. The 2-year Treasury yield has surged to 2.72%, reflecting the projected interest rate hikes by the Fed and depicting a flatter yield curve, a sign that typically signals a slowing economy.

Last Week

Leading economic indicators for March rose modestly and were in line with estimates, signaling that economic growth is likely to continue through 2022 despite headwinds from high inflation, weakening business and consumer expectations and the war in Ukraine. Housing starts and building permits in March were higher than expected while existing home sales were slightly lower than in the same period in 2021. Weekly jobless claims were 184,000, a decline of 2,000 from the previous week and slightly above the estimate of 182,000.

The World Bank lowered its annual global growth forecast for 2022 from 4.1% to 3.2%.

For the week, the Dow Jones Industrial Average lost 1.9% to close at 33,811 while the S&P 500 Index declined 2.8% to close at 4,272. The Nasdaq Composite Index dropped 3.8% to close at 12,839.

This Week

The preliminary estimate for first quarter gross domestic product (GDP) is expected to be 1.7%, down sharply from 6.9% in the fourth quarter. March durable goods orders are forecast to increase modestly after falling in February while March new home sales should be slightly higher than those reported last month. Both the April consumer confidence index and the University of Michigan consumer sentiment index are expected to approximate readings in March, which have been negatively affected by soaring prices.

More than a third of S&P 500 companies are scheduled to report first quarter earnings this week, including Alphabet (Google), Meta Platforms (Facebook), Microsoft, Apple, Amazon, Texas Instruments, Intel, Qualcomm, 3M, General Electric, Ford Motor, General Motors, Waste Management, Boeing, Caterpillar, PepsiCo, Coca Cola, McDonald’s, Archer Daniels Midland, Visa, Mastercard, United Parcel Service, Amgen, Merck, Eli Lilly, Bristol Myers Squibb, Abbvie, Exxon Mobil and Chevron.

Portfolio Strategy

It’s been a rough April for the stock market so far as the S&P 500 Index has declined for three straight weeks as sentiment has been affected by high inflation and rising interest rates, both of which could cause an economic slowdown. It will be a very busy week for quarterly earnings reports, especially in the technology sector, as most of the bellwether companies with the largest market capitalizations are scheduled to report. The profit results so far have been encouraging, although earnings estimates have been lowered in recent months as the economy has slowed. Much of the good earnings news has been overshadowed by persistently high inflation, rising bond yields and concern that the Federal Reserve may raise interest rates too aggressively, putting the brakes on an already weakening economy. Investors will receive an update on inflation on Friday when the core personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, is released. The reading in February was over 5% with volatile food and energy prices excluded, but these prices have risen substantially and have hurt consumers. These price increases have been partly due to supply constraints, but the Federal Reserve does not have the luxury of waiting any longer for them to be resolved. There were signs in the March inflation data that prices may have peaked, but Federal Reserve Chairman Jerome Powell said he couldn’t be sure and vowed that it was essential to achieve price stability. This tough talk on inflation rattled investors as a dovish Fed seems like a distant memory along with 25 basis point increment hikes. The market is pricing in a 50 basis point hike in May and possibly a 75 basis point increase in June.