Higher-than-expected inflation data slammed investor expectations and rippled through markets, causing a broad selloff, and we may see more volatility in the weeks to come.
Here’s a look at what’s going on, and what could happen next.
Why Are The Markets Selling Off?
Investors were hoping that tamer inflation would cause the Federal Reserve to pull back on its interest rate hikes. But unfortunately, Consumer Price Index (CPI) data from August revealed that inflation rose unexpectedly.
As a result, the Fed announced a third-straight three-quarter-point interest rate hike last week, and is likely to continue aggressive rate hikes in the months to come. All of this is spooking investors who expected a pivot away from higher rates.
When the central bank sets higher interest rates, it increases the cost of credit across the entire economy, making mortgages, car loans, credit cards and business financing more expensive. Investors worry that these higher rates will slow the economy (and maybe tip it into a recession) and lower company performance.
Higher interest rates could also make investors less willing to accept steep valuations amid risks to future earnings growth.
What Could Be the Longer-Term Impact of Rate Hikes?
Whenever we want to understand what could happen, it’s useful to go back in time to look at what has happened before. While the past can’t predict the future, it’s often a useful guide.
An analysis of 12 previous rate hike cycles shows that, overall, equity markets handled tightening reasonable well. Across these cycles, the S&P 500 averages a total return (including interest, dividends, etc.) of 9.4%.
So, what can history teach us?
- Stocks tended to take rate hikes in stride over time.
- However, those historical gains didn’t come in a straight line. They included dips, shocks, sell offs and bear markets. They even included a few recessions.
- Investors who bailed on the ride down probably missed a lot of the ride back up.
- Predictions are a murky business. While what happened in the past is useful to a point, it’s not a map of the future.
What’s the Bottom Line?
We think that more volatility is in the cards in the days and weeks ahead. As investors digest the Fed’s decision, economic data and Q3 corporate earnings, we’re going to see some reactions – positive and negative.
However, we don’t think it’ll all be gloom and doom. Markets can overreact at times, forgetting that there’s a lot of uncertainty and margin for error in economic data – statistical agencies have to walk a thin line to get data out quickly (so it’s useful to decision makers) while being transparent about how much error is baked into their estimates.
We will keep an eye on the markets and the economy, and update this series with more insights as we have them.