The first 21 months of the COVID-19 pandemic were tough for human beings. But they were spectacular for stock markets. The S&P 500 ended 2020 worth 16 percent more than it had been at the year’s onset. In 2021, the index climbed another 27 percent.
Alas, this January has sent a chill down equity traders’ backs.
America’s major stock indexes have declined for three straight weeks. And on Monday morning, shares fell further still, with the S&P 500 shedding another 2.4 percent in value, bringing the benchmark index down to “correction” levels, a threshold defined as a 10 percent drop from a near-term high. Even after an afternoon rally erased the morning’s losses, the S&P 500 remains on pace for its worst month since March 2020’s COVID crash — and its worst start to a year in recorded history.
Many Wall Street analysts believe that stocks remain far from their bottom. Morgan Stanley’s Michael Wilson, deploying a years-stale Game of Thrones reference, declared Monday that “winter is here” for equities. Legendary asset manager Jeremy Grantham, meanwhile, insists that we’re witnessing the catastrophic pop of the fourth “super bubble” of the past century. Some traders are more bullish about the market’s medium-term fortunes. But virtually all see near-term turmoil and are putting their money where their mouths are.
So, what explains the sudden death of the pandemic rally? Myriad factors have contributed to the markets’ woes, but three developments have been especially critical:
1) The Federal Reserve is removing “the punch bowl.”
The S&P 500 forfeited its high on January 5, when Fed officials unveiled the minutes of their December policy-making meeting. Those notes revealed that the central bank expected to raise interest rates three times in 2022, in light of the tightening labor market and persistent inflation. This was a faster pace of monetary tightening than many traders had anticipated, and they adjusted their portfolios accordingly.
By itself, the Fed’s notes didn’t trigger a stampede for the exits. But it durably shifted the mood among investors. And the new climate of bearishness was reinforced a week later, when new data revealed that December had witnessed the highest rate of inflation in four decades, a development that seemed likely to reinforce the Fed’s inclination toward tightening.
Central bank policy always influences stock-market values. Equities compete with bonds for the world’s savings. When benchmark interest rates are low, stocks become a better value proposition, as the alternative to investing in risk assets is to accept little to no return on one’s capital. Savings therefore flood into stocks, propping up their value. By the same token, when interest rates rise, the relative appeal of bonds does, too, and savings slosh out of equities and into Treasuries.
But the pandemic rally was even more sensitive to central-bank policy than most. After all, the Fed arrested the March 2020 crash — and birthed the ensuing boom — by taking unprecedented measures to increase the appeal of risk assets. Since the pandemic’s onset, the central bank has not only kept short-term interest rates near zero, but also bought upwards of $80 billion in Treasuries every month. These purchases put further downward pressure on rates by ensuing healthy demand for the government’s bonds, no matter how low their return.
The stratospheric highs of the major stock indexes reflected this tilted playing field more than it did conventional measures of their companies’ likely future earnings.
Further, in part because the pandemic disrupted in-person service and retail firms more than digital giants, the COVID-era rally was powered by tech stocks. At the end of 2021, more than half of the S&P 500’s value derived from Apple, Microsoft, Amazon, the company formerly known as Facebook, Alphabet, Tesla, and the chipmaker Nvidia.
Alas, tech stocks, especially smaller ones, are even more vulnerable to rising interest rates than the typical equity. This is because most tech firms are valued for their long-term growth potential. When the return on safe assets is negligible, the cost of locking up one’s capital in a risk asset that won’t pay off for years isn’t very high. But the more risk-free interest a present-day dollar buys, the less appeal “growth” stocks have.
In 1955, then-Fed chairman William McChesney Martin argued that the central bank’s job during inflationary booms was to serve as the “chaperone” who “has ordered the punch bowl removed just when the party was really warming up.” One might say that, in the present context, the Fed is removing a punch bowl that it had previously spiked with MDMA, just as the partygoers’ serotonin levels were starting to fall.
And traders fear that Jerome Powell & Co. will become even bigger party-killers after their meeting this week, in part because of another adverse development:
2) The odds of inflation dissipating in 2022 have declined in recent weeks.
When consumer prices first began spiking last year, both the Federal Reserve and investors were unperturbed. In their view, inflation would prove “transitory.” As the economy reopened, demand was bound to temporarily run ahead of supply, especially in sectors that were hard-hit by the pandemic. In time, however, markets would recalibrate. After all, an outsize portion of price increases were concentrated in a small number of goods. Once automakers revved up production, falling car prices alone would take a large bite out of inflation.
A heavily caveated version of this analysis remains plausible. Although inflation has proven more persistent than the Fed had hoped, it remains relatively narrowly distributed. More than half of December’s 7 percent CPI increase derived from spikes in the prices of energy, new vehicles, and used vehicles. As Leslie Lipschitz and Josh Felman note in Barron’s, if you assume that the prices of those products will stay flat through 2022, while others continue to rise at their present rate, then inflation will fall by 4 percentage points this year.
Yet markets can no longer have much confidence in an imminent stabilization of prices. If the pandemic subsides come springtime, that could ease some supply-side woes in the automotive sector. But it might simultaneously drive a demand-induced surge in the prices of restaurant meals, airline tickets, and hotel fares. More critically, the consumer-price index does not currently reflect the soaring cost of housing in the United States. The rate on a new lease is between 15 and 20 percent higher today than it was one year ago. The CPI’s measure of shelter costs remain dampened because a lot of tenants are still paying rental rates that were set nearly a year ago. As leases turn over, however, that measure will soar. And since housing accounts for such a large share of the typical American consumer’s spending, a 15 percent increase in rents would translate to a four-point increase in overall inflation.
Meanwhile, private demand is likely to remain robust through 2022, as newly hired workers find themselves with more disposable income and middle-class Americans still have plenty of excess savings left to burn through.
Beyond these structural forces, there’s a growing risk of a contingent inflationary shock. Russia is the world’s No. 2 oil producer, and Ukraine is one of the world’s leading energy hubs. Should the former invade the latter, analysts say that the price of oil could shoot up past $100 a barrel. Meanwhile, China’s “zero-COVID” policy is all but certain to fail when pitted against the exceptionally transmissible Omicron variant. Given the relatively low levels of natural immunity against COVID among the Chinese population, Omicron has the potential to cause severe outbreaks in the world’s largest exporter, further exacerbating supply-chain difficulties.
If inflation were to once again exceed the Fed’s expectations, it could raise interest rates by even more than its December minutes projected. Such an occurrence would not only reduce the relative appeal of stocks to bonds, but also threaten to derail the broader economic recovery, depressing profits in the process.
3) Corporate earnings have been a mixed bag.
Finally, corporate earnings have not been robust enough to ease investors’ anxieties. Which isn’t to say that it’s been an especially bad earnings season. About one-fifth of the companies in the S&P 500 have filed their fourth-quarter results, and 82 percent of these firms beat analysts’ expectations. But stock valuations are forward-looking. And companies’ guidance to investors — which is to say, their official expectations for earnings in the months to come — has been lower than anticipated, with only a single S&P 500 corporation, Micron Technology, beating earning estimates and raising its expectations for future profits.
None of this means that the present correction is bound to turn into a full-blown crash. It remains possible that, in the coming months, supply-side bottlenecks will ease, tensions between Russia and Ukraine will blow over, Omicron will leave Chinese exporters unscathed, and falling goods prices will mitigate the influence of rising rents. In such a scenario, inflation will cool off, the Fed will leave out a little punch, and stocks could very well recover their lost highs.
But for the moment, investors aren’t betting on it.