Major stock averages tumble as Fed raises rates again

It’s the nature of stock markets to go way down from time to time. There’s no system to avoid bad markets. You can’t do it unless you try to time the market, which is a seriously dumb thing to do. Conservative investing with steady savings without expecting miracles is the way to go. – Charlie Munger 

It was another volatile week for the financial markets and the volatility was to the downside as the major stock averages all closed significantly lower after the Federal Reserve raised the federal funds rate by 0.75% as predicted. The Dow Jones Industrial Average dropped 4%, its lowest close of the year and nearly 20% off its all-time high on the precipice of a bear market. The Nasdaq Composite Index with its substantial composition of technology stocks fared even worse with a loss of 5%, the second straight week it has fallen by that amount. While expectations were for a 75-basis point (a basis point is one-hundredth of one percent) increase, what wasn’t expected was the Fed’s intention to continuing raising rates until the “terminal” rate hits 4.6% in 2023. That level is higher than what the market had been pricing in for next year. The range in the federal funds rate is now between 3.0% and 3.25%, the highest level since 2008, as the Fed is determined to bring down inflation, which is running at its highest level in 40 years. In fact, the central bank forecast no interest rate cuts until 2024 and Fed Chairman Jerome Powell admitted that a recession is possible if the tightening cycle has to continue to accomplish its goal. This forecast calling for still more rate hikes sent bond prices tumbling (bond prices and yields move in opposite directions) as the 2-year Treasury yield soared to 4.1%, its highest level in 15 years, while the 10-year Treasury yield rose to 3.70%. The spread between the two has widened considerably and continues to be inverted, an ominous sign that a recession may be on the way. Concerns about slowing global economies also affected the price of oil as West Texas Intermediate fell to about $79 a barrel, its lowest level since January. The S&P 500 Index is now back to where it was before it reached its low in mid-June and is extremely oversold on a valuation basis. Unfortunately, there is still a lot of uncertainty with regard to the paths of inflation, economic growth, interest rates and corporate earnings, which could make for more volatility over the near-term.

Last Week

Most of the economic data released last week was weaker than expected as the Fed’s policies seem to be working. The leading economic index in August fell for the 6th straight month, raising the possibility of a recession, while existing home sales also fell and were at the slowest pace since June 2020. Building permits  plunged more than expected in August and the National Association of Home Builders (NAHB) index for September showed homebuilder sentiment fell for the 9^th straight month as mortgage rates have increased. Weekly jobless claims rose by 5,000 to 213,000 but were less than forecast, suggesting that the labor market remains strong.

The Bank of England raised its benchmark interest rate by 50 basis points to 2.25%, but the Bank of Japan (BOJ) kept its benchmark interest rate at negative 0.1% as the Japanese economy remains weak.

For the week, the Dow Jones Industrial Average fell 4.0% to close at 29,590 while the S&P 500 Index dropped 4.7% to close at 3,693. The Nasdaq Composite Index lost 5.1% to close at 10,868.

This Week

August durable goods orders are expected to be flat while August new homes sales are forecast to decline by about 20,000 from July. Both the September consumer confidence index and the University of Michigan consumer sentiment index are expected to be on a par with August but much lower than levels reached last summer.

The most notable companies scheduled to report second quarter earnings this week are Micron Technology, Nike, Cintas, Rite Aid, CarMax and Paychex.

Portfolio Strategy

The sell-off in the stock and bond markets last week was not confined to the U.S. as markets around the world were also weak as global central banks raise interest rates to fight high inflation. Not only did the Federal Reserve raise its “terminal” or end point for the federal funds rate, but Federal Reserve Chairman Jerome Powell also admitted that the odds of a recession have increased if the Fed must continue to tighten monetary policy. In his post-meeting comments, Powell conceded that he doesn’t know how long this process will take, but that a recession would help bring down inflation. The European Central Bank (ECB), faced with similar high inflation caused by supply chain disruptions from Covid and Russia’s invasion of Ukraine that caused an energy crisis, has been raising interest rates from negative to positive to combat the same problem. Global central banks are also ending bond purchasing programs at the same time that they are raising interest rates, slowing economic growth even further. Recession fears have caused commodity prices for metals, energy and agricultural products to fall and the Fed has forecast that unemployment could rise to 4.4% next year from 3.7% now. The core personal consumption expenditures (PCE) index for August will be released this week and is expected to decline to 4.5% this year, a slight decrease from its current level. This is the Fed’s preferred measure of inflation and has been running well below the consumer price index. Until inflation begins to subside and interest rates begin to drop, the markets are likely to remain volatile, especially with the Federal Reserve unsure what the final outcome will be.