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Stocks close lower after the Federal Reserve raises interest rates

The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell. – Sir John Templeton  

The stock market took investors on another wild roller coaster ride last week and when the ride came to an end on Friday, both the Dow Jones Industrial Average and the S&P 500 Index posted modest losses while the technology-laden Nasdaq Composite Index was the biggest loser again with a loss of 1.5%. The reason for the extreme volatility was the Federal Open Market Committee (FOMC) meeting, which raised the federal funds rate by half a percentage point on Wednesday as expected. When Federal Reserve Chairman Jerome Powell said afterward during his press conference that the Fed “is not actively considering” a larger 75 basis point (a basis point is one hundredth of one percent) rate hike at subsequent meetings, investors cheered and stocks rallied. However, those same investors had second thoughts on Thursday when the yield on the 10-year Treasury rose above 3% and the stock market plunged, giving back all of the previous day’s gains and then some. In addition to the increase in the federal funds rate, the Fed will also reduce its bond holdings, which total about $9 trillion, by $95 billion a month in a process known as quantitative tightening. The rate hike raised the federal funds interest rate to a range of 0.75% to 1.00% with the market pricing in a range of between 2.75% and 3.00% by the end of the year. The rate increase was the largest since 2000 and is in direct response to soaring inflation, which is at the highest level in forty years. Needless to say, the prospect of more Fed rate hikes negatively impacted investor sentiment and affected growth stocks with high valuations more severely.  The stronger than expected April employment report released on Friday only compounded the Fed’s problem.  Average hourly earnings rose in the month and are up over 5% on a year-over-year basis, contributing to broad-based inflation as demand for labor remains strong. The worry is that the Fed will raise interest rates too aggressively as it fights inflation and cause the economy to slow substantially and possibly enter a recession.

Last Week

Data on jobs last week was mixed. The April employment report showed that 428,000 new jobs were created, compared to estimates of 400,000, and that the unemployment rate was unchanged at 3.6%. ADP reported that private sector jobs grew by 247,000 in April, well below forecasts of 395,000 and the smallest gain in 2 years. Weekly jobless claims also rose to 200,000, well above the estimate of 182,000 and an increase of 19,000 from the previous week. Both the ISM manufacturing and services sector indices for April fell slightly and were less than expected as high inflation, labor shortages and high employment costs remain headwinds. However, both readings were still comfortably above 50, indicative of continued growth.  Factory orders for March were better than expected.

For the week, the Dow Jones Industrial Average fell 0.2% to close at 32,899 while the S&P 500 Index also declined 0.2% to close at 4,123. The Nasdaq Composite Index dropped 1.5% to close at 12,144.

This Week

Inflation data will be the key focus this week as the consumer price index (CPI) for April is expected to increase about 8% year-over-year, less than in March, while the producer price index (PPI) is forecast to increase about 10.5% year-over-year, also less than in March.  Although inflation will likely remain elevated, there is hope that these numbers will show that inflation has peaked. The University of Michigan consumer sentiment index for May is expected to be slightly less than in April due primarily to inflation worries.

The most prominent companies that are scheduled to report quarterly earnings this week are BioNTech, Duke Energy, Occidental Petroleum, Exelon, Simon Property Group, Wynn Resorts, Tyson Foods, Sysco, Walt Disney, Wendy’s, International Flavors & Fragrances, Electronic Arts, Motorola Solutions, Toyota Motor and Rivian Automotive.

Portfolio Strategy

Although there are a number of companies that are scheduled to report their first quarter earnings results this week, the focus instead will likely be on the inflation data, especially the consumer price index (CPI) for April.  The reading in March was 8.5% and most economists expect the CPI to come in slightly below that number, suggesting that inflation may have peaked. If that happens to be the case, then both the stock and bond markets may be able to stabilize and consolidate around current levels. The prospect of the Federal Reserve aggressively hiking interest rates to combat inflation has caused bond yields to rise across the yield curve. After beginning the year at about 1.5%, the yield on the 10-year Treasury climbed to over 3.1% on Friday while the 2-year Treasury yield eclipsed 2.7%. (Bond yields and prices are inversely related). As bond yields have risen, the stock market has continued to fall with most of the damage occurring in growth and technology stocks that typically have high valuations and provide little or no dividends. The 10-year Treasury also serves as a benchmark for many lending rates, including mortgage rates and rates on consumer and business loans. Higher rates could slow the economy and lead to stagflation in which stagnant growth coupled with high or rising inflation leads to high unemployment. While this scenario is not the most likely outcome, it is a worry that is creating uncertainty for investors and weakness in the stock market. Following the Federal Open Market Committee (FOMC) meeting last week, Fed Chairman Jerome Powell said that he remains hopeful that the Fed can engineer a soft landing; one that results in slower economic growth, avoids a recession and reduces inflation to an acceptable level.