Stocks drop as recession fears, Fed interest rate hikes grip the market

As I have said before, the daily machinations of the stock market are like a tale told by an idiot, full of sound and fury, signifying nothing. – John Bogle

The stock market often rises and falls from week to week on nothing more than fear and greed and the past two weeks of market action demonstrate this fact. After Federal Reserve Chairman Jerome Powell commented that smaller interest rate increases would likely occur in the future and that a soft landing for the economy was still possible, the stock market rallied and posted healthy gains the week of December 5^th. Last week that optimism turned to pessimism as a Wall Street Journal article hinted that Fed officials could change their forecast and raise the terminal federal funds rate next year. Fears about a recession in 2023 also gripped the market last week and the major stock averages all tumbled. The technology-heavy Nasdaq Composite Index led the way with a loss of nearly 4% while the broad-based S&P 500 Index plunged 3.4%. An inverted yield curve only added to those fears as the yield on the 2-year Treasury climbed to 4.48% while the 10-year Treasury yield rose to 3.58%, a difference of 90 basis points. (A basis point is one hundredth of one percent). History shows that the odds of a recession increase when the yield curve inverts, or when the 2-year Treasury yield exceeds the 10-year Treasury yield. The size of the inversion doesn’t matter, but a recession typically occurs within the next 24 months. This time may be different, though, as the bond market may believe the Fed is going to win the battle against inflation, resulting in a lower yield on the longer-term Treasury. The only potential market-moving piece of economic data released last week was the producer price index (PPI) for November. Although both the headline number and the core PPI number that excludes food and energy prices were slightly higher than expected, the year-over-year producer price index was lower than in October for both measures. Core PPI was up 6.2% from a year ago compared to 6.6% in October. This week investors will be bracing for the November consumer price index (CPI) report as well as the results of the Federal Open Market Committee (FOMC) monetary policy meeting, both of which could determine the path of the stock market between now and year-end.

Last Week

The November ISM non-manufacturing or services sector index was better than expected and higher than in October with a reading in the mid-50s, a sign of solid expansion. Factory orders in October were also higher than forecasts while weekly jobless claims were basically in line with estimates and 4,000 higher than in the previous week. The University of Michigan consumer sentiment index in December was better than expected and higher than in November as consumers grew more optimistic about the economy and less concerned about inflation.

For the week, the Dow Jones Industrial Average lost 2.8% to close at 33,476 while the S&P 500 Index declined 3.4% to close at 3,934. The Nasdaq Composite Index plunged 4.0% to close at 11,004.

This Week

The consumer price index (CPI) for November is expected to increase about 7.3% year-over-year compared to a 7.7% increase in October while the core CPI is also expected to increase but less than in October. Import prices in November are forecast to decline and fall by more than in the previous month. Retail sales in November are expected to be flat month over month.

The Federal Open Market Committee (FOMC) meets to review its monetary policy and is expected to raise the federal funds interest rate by 50 basis points in keeping with Fed Chairman Jerome Powell’s comments during his last speech. The European Central Bank (ECB) also meets this week to discuss its monetary policy.

The only notable companies scheduled to report third quarter earnings this week are Oracle, Adobe, Lennar, Darden Restaurants, Winnebago Industries and Accenture.

Portfolio Strategy

This week could be a pivotal one for the stock market and determine whether a Santa Claus rally happens to end the year or stocks resume their downward trend amid increased volatility. On Tuesday investors will receive important inflation data in the form of the November consumer price index followed by the Federal Reserve’s decision the next day on interest rates as well as comments by Fed Chairman Jerome Powell after the meeting. After four consecutive three quarters of a percent interest rate hikes, the futures market is predicting a half point increase that will bring the federal funds rate to between 4.25% and 4.50%. The results of the CPI data the day before the FOMC meeting could very well dictate the Fed’s policy response. A better-than-expected inflation reading could lead to a stock market rally on Tuesday but prompt the Fed to become more hawkish in order to squash hopes of a Fed pivot or a potential decline in rates. The Fed is determined to bring down the high rate of inflation and does not want investors to get any ideas of a softening in that position. The peak in the federal funds rate is forecast to be slightly above 5% by mid-2023, but any increase in that projection could be problematic for both growth stocks and bond prices as yields would likely rise. But the markets have digested a lot of bad news this year, namely surging inflation, Federal Reserve tightening, uncertainties and lockdowns in China and the ongoing Russian & Ukrainian war, and they have held up rather well recently. This set-up could be bullish as the stock market is heading into what has been a seasonally good period for stocks.