A rise in the price of goods and services has an impact on the valuations of stocks. In 2022, US stock market investors witnessed such an impact. As the US economy felt the brunt of 40-year high inflation, US stocks went into a tailspin once the inflation that was initially recognized as ‘transitory’ by the US Fed appeared to be a real danger to the economy. But, how do inflation and the steps taken by US Fed actually impact the market?
A recent report titled “Insights on Passive Investment” by Mirae Asset Mutual Fund puts down the factors that led to a multi-decade high price rise in the US. The report says that the in US, the over 2 trillion dollars of household savings led to a pent-up demand, which when combined with supply chain issues due to pandemic-induced lockdowns and frequent disruptions in China paved way for 40-year high inflation in the US. UK and Europe also reeled under high inflation which also got further driven by high energy (gas) prices, supply chain disruptions, and food inflation due to the Russia-Ukraine war.
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Rising inflation impacts equity valuations. The value of equity investments declines when central banks start hiking interest rates to control inflation. And, this is exactly what transpired in 2022. The macroenvironment, which for almost a decade, especially after the pandemic, appeared to be favourable for the rise of risky assets, unexpectedly turned out to be disadvantageous.
The US fed started increasing the Fed rate aggressively in 2022 and other central banks followed suit. “In 2022, the US has raised rates by 4.25%, UK by 3.25% and Europe by 2.5%. The phenomenon of quantitative tightening in order to tackle the inflation led to a downfall in the equity which further got entrenched by a downward revision of earning estimates excluding energy,” is what the report suggested.
As of January 17, the S&P 500 Index is down by 14%, over the last 1-year period. The tech-heavy index, Nasdaq-100, which had a phenomenal run in 2021 is down by 26%. Despite inflation cooling down from 7.7% in October to 6.5% in December, the bullish sentiment in the US stock market is lacking.
The inflation may be seen to be cooling down but the US Fed has a task at hand – to bring annual price rise under 2%. Markets are expecting the terminal rate to go beyond 5% by the time inflation could appear to be tamed. How much damage the rate hikes does to the economy and companies’ earnings growth remains to be seen, which is keeping the bulls at bay.
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“Despite this gloomy backdrop, investors are heading into 2023, stuck somewhere between hope and fear. We anticipate that the next 12 months will be equally challenging for investors. The soft landing of the US economy, if not the recession along with elevated inflation will require the central bank to strike the right balance between too much and too little of monetary tightening” is what the report adds.