After two years of increases and records in the Wall Street indices, in 2022 red is leading a good part of the closings of markets that are already accumulating significant losses. The index S&P 500 has lost almost 8% so far this year, the Dow Jones 5% and the Nasdaq almost 12%.
Furthermore, the collapse of technology companies, led by the Meta Platform (formerly known as Facebook) and other high-growth companies has caused the S&P 500 to trade in late January below its 12-month earnings projections from the start of the year. It went from a multiple of 21.5 to 19.3, according to data from FactSet, in just one month.
With these valuation downgrades emerge attractive investment opportunities not seen for two years. However, money is cautious and hesitant at a time full of uncertainty and volatility. Why?, for the questions regarding the pace of the Fed’s tightening of monetary policy given the sharp rise in inflation.
To that is added the conflict in Ukraine and its effect on the economyespecially its impact on the price of raw materials such as gas and oil.
Goodbye to ‘free’ money
A large part of the rise in the stock market in the last two years has a lot to do with the fact that in order to contain the crisis caused by the COVID pandemic the monetary authority launched a battery of stimulus measures in the spring of 2020. The reductions in interest rates to 0%-0.25% and the injection of liquidity with the purchase of treasury bonds and titled mortgage debt (the so-called QE, quantitative easing) allowed investors a lot of comfort to bet even on high-risk securities.
The improvement of the economy, especially in 2021, has allowed these bets to be later validated in strong company profits, especially compared to the results of a bad previous year dominated by activity closures due to the pandemic.
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And this framework has to be dismantled, not only because the emergency of the pandemic has been reduced, but also because of the sharp rise in inflation. Currently this is 7.5% higher than in January last year. Core inflation (to which the more volatile price of food and energy is subtracted) is 6% and is making the many analysts expect the Fed to raise interest rates five or six times this year and that the first can be 50 basis points (or 0.5 percentage points) instead of 0.25%.
On Tuesday it was revealed that producer prices (PPI) rose 1% in January leaving the year-on-year increase at 9.7%, a record that also doubles analysts’ estimates. It is a rise that will reach businesses in the form of higher costs and consumers who will pay higher prices.
Obsession with inflation and lower profits
FactSet has analyzed analyst conference calls and found that of the 337 S&P 500 analysts reporting results from mid-December through Feb. 10, 246 have cited the word inflation. This figure is expected to rise when the accounting season is over.
In his note to investors, FactSet analyst James Butters explains that the estimate of net earnings for the first quarter and the year are slightly below what was calculated just a month and a half ago.
Faced with such evidence and the possibilities of an increase in energy prices given the situation in Ukraine, Barclays explained on February 14 to its clients that central banks “have been forced to abandon their narrative that inflation is transitory and are now preparing for a much earlier hike.” The president of the Federal Reserve of Saint Louis, James Bullard, has reiterated that wait for decisive action to start.
In statements to CNBC, he explained that the Fed should have rates at 1% in July and it is something that he will try to convince the other members of the monetary authority. It will not be easy because there is a certain consensus that these rapid measures can be destabilizing.
If the rate hikes leave investors cold despite the opportunities, the effects of what the Fed might do in unwinding a balance sheet that is some $9 trillion is a question mark.
David Kotok, president and chief strategy officer of Cumberland Advisors summed up his sentiment in just one paragraph in a communication with clients.
“The questions regarding interest rates are: 1. How much will they go up? 2. How fast? and 3. the biggest mystery, how will the Fed’s balance sheet reduction affect markets and financial stability? The answers: 1. We don’t know. 2 We don’t know. 3. We really, really don’t know.”
