The US stocks enjoyed a relief-rally overnight on the expected Fed’s rate-hike, with the tech-heavy index, Nasdaq jumping 3.77%, following a 3% rally of the previous day. Risky assets bounced on the Fed’s decision as an increase of 25-basis-points was widely expected, and the projection of the further monetary policy was not so aggressive as previously estimated. In fact, the stock markets moved higher as the interest rates rose in all the past monetary tightening cycles, which is opposite to what the everyday theory suggests.
Nasdaq Composite vs. Federal Funds Composite Interest Rate (2009-2022)
What is in the Fed’s policy?
The Fed raised interest rates by 25 basis points for the first time since 2018 and projected a further six rate hikes this year. The committee mentioned it plans to start shrinking its US$8.9 trillion balance sheet at the coming meeting but did not give details for the timeframe and size while addressing that Russia’s invasion of Ukraine causes greater uncertainty for the US economy.
The Fed members see inflation at 4.3% this year, 2.3% in 2024, higher than previously estimated. The committee lowered the economic growth outlook to 2.8% from 4% in 2022.
What are the key elements that drive the stock market’s performance?
From the macro point of view, stocks markets' performance is based on economic growth and the company’s earnings in the long run. From the below two graphs, the S&P 500 has a positive correlation with the US GDP growth. In the recent 3 recessions that happened in early 2000, 2008, and 2020, the stock markets all had downturns, while the economy turned around to positive growth, the stock markets also returned gains.
In the micro perspective, the valuation of a company’s shares is based on the company’s growth, dividend, and yields. Higher interest rates will technically reduce the future value of money because of the reducing supply, but it doesn’t necessarily mean a tightening monetary cycle will stop businesses from growing. It is why the growth stocks have been outperforming cyclical sectors due to the mega capitalization and fast-growing earnings, in which we can see the technology pioneers, such as electric car makers, chipmakers, and social media, are in this group.
The concerns of the current stock markets
At this moment, the risks that the stock markets are facing are high inflation and an aggressive monetary tightening pace. Supply-chain disruptions, labor shortage, soaring energy, and raw material costs all contribute to flaring inflation in the post-pandemic era. Consumer affordability becomes a serious concern when wages growth is not pacing up with the consumer price increase. On the other hand, fast rate-hikes will hurt liquidity and reduce demand, which will not resolve the supply side of issues that drive up inflation, all of which are pointing to slower economic growth.
To conclude, when people are concerned about whether there will be an inflation-induced recession, a slowing down economic growth should be the consideration in the first place, in turn weakening the speed of growth in the stock markets. Investors need to closely watch how companies’ performance in the first quarter and assess the degree of impact of a tightening monetary policy to make the investment strategies.