Stocks decline as hawkish Fed comments outweigh positive CPI data

The stock market is never obvious. It is designed to fool most of the people, most of the time. – Jessie Livermore, was an American stock trader

What began as a positive week for the major stock averages after a favorable piece of inflation data abruptly turned negative on Wednesday following the Federal Open Market Committee (FOMC) meeting. The Nasdaq Composite Index plunged nearly 3% while the S&P 500 Index and Dow Jones Industrial Average fell about 2%, the second straight week that all three indexes posted a loss. In anticipation of a decline in the November consumer price index (CPI), stocks rallied on Monday and continued their ascent on Tuesday when the core CPI rose just slightly and 6% on an annual basis, below estimates and the smallest increase since November 2021. Investors thought that the improvement in the inflation data would certainly take pressure off the Federal Reserve for raising interest rates. That thinking didn’t last long, however, as the very next day the Fed raised the federal funds rate as expected by 50 basis points (a basis point is one hundredth of one percent), taking the targeted range to between 4.25% and 4.5% and increasing the benchmark rate to the highest level in 15 years. While this move by the Fed was no surprise, what was a shock to investors was that officials forecast that rates would remain high through 2023 with no reduction until 2024 at the earliest. The expected “terminal rate”, or the level at which the federal funds rate peaks, was placed at 5.1% as the Fed vows to keep rates higher for longer to ensure that inflation is eventually lowered to its targeted rate of 2%. Investors reacted negatively to the news as the stock market slid to end the week in the red. The worst inflation in over 40 years has resulted from excessive demand for goods during the pandemic that created supply chain issues, Russia’s invasion of Ukraine that led to a spike in energy prices and trillions of dollars in monetary and fiscal stimulus. In hindsight, the Fed should have begun the tightening process much earlier and now may be raising rates too high, too fast, which ultimately could cause the economy to fall into a recession.

Last Week

Import prices in November fell for the fifth straight month and more than expected, helped by declining oil prices and a strong dollar. Retail sales in November dropped more than expected as consumers were negatively impacted by high inflation. With weak global growth and high interest rates, the weakness could continue. Weekly jobless claims fell to 211,000, a decline of 20,000 from the previous week and well below the estimate of 232,000.

For the week, the Dow Jones Industrial Average lost 1.7% to close at 32,920 while the S&P 500 Index dropped 2.1% to close at 3,852. The Nasdaq Composite Index declined 2.7% to close at 10,705.

This Week

November housing starts, existing home sales and new home sales are all expected to be less than in October in what has been a difficult year for the housing market due to rising mortgage rates and elevated home prices. Leading economic indicators for November are forecast to fall slightly while November durable goods orders are also expected to decline after increasing in October. The final estimate of third quarter gross domestic product (GDP) is expected to remain unchanged at an annualized 2.9% growth rate. Both the December consumer confidence index and the University of Michigan consumer sentiment index are forecast to remain unchanged from readings the previous month.

The Bank of Japan (BOJ) meets to review its monetary policy and is widely expected to leave its benchmark interest rate unchanged at negative 0.1%.

The only prominent companies scheduled to report third quarter earnings this week are Nike, General Mills, FedEx, Cintas, CarMax, Paychex and Micron Technology.

Portfolio Strategy

It has been a particularly bad year for bond investors as the Federal Reserve has aggressively raised interest rates to combat high inflation, resulting in much lower bond prices. (Bond prices and yields move in opposite directions). The Bloomberg U.S. Aggregate Bond Index has lost about 11% this year and funds that track high yield securities, long-term Treasury bonds and investment grade corporate issues have suffered double-digit losses as well. The silver lining in this upward move in interest rates is that bond yields are much more attractive now and offer investors a better income stream. The 10-year Treasury currently yields 3.5% after starting the year at just 1.5% while the 2-year Treasury yields 4.25% following the Fed’s half a percentage point increase last week and four 75 basis point hikes prior to that. With so much uncertainty surrounding the   inflation outlook and the Fed’s forecast of raising the federal funds rate, it makes sense for investors to stay relatively short in their fixed income portfolio. Exchange-traded funds (ETFs) that invest in short-term bonds offer yields above 4% and provide a way for investors to greatly reduce interest rate risk, or the risk of bonds falling in value as interest rates rise.  Two such ETFs are the Vanguard Ultra-Short Bond ETF (VUSB) and the JP Morgan Ultra-Short Income ETF (JPST), both of which invest in U.S. government issues, asset-backed securities and investment grade corporate bonds. The Vanguard ETF currently yields 4.6% and has an average maturity of just 0.8 years while the JP Morgan ETF yields 4.3% and has an average maturity of only 0.5 years. Vanguard also offers an ETF with a slightly longer average maturity of 2.8 years, the Vanguard Short-Term Bond ETF (BSV), and this fund currently yields 4.5%. All of these ETFs have a very low expense ratio, too. In a difficult year for bond investors, their performance has been outstanding as the two ultra-short bond ETFs have lost less than 1% while the Vanguard Short-Term Bond ETF is down less than 5%.