The S&P 500 is trading 8% higher than before the Fed started hiking interest rates. Why that's surprising - but perhaps it shouldn't be.
Theron Mohamed
Fri, December 15, 2023
The S&P 500 is trading 8% higher today than it was before the Fed started hiking rates last spring.
That's surprising as higher rates hit earnings and economic growth, and make stocks less appealing.
Investors may be betting inflation is over, a recession has been avoided, and rates are coming down.
The S&P 500 is trading 8% higher today than before the Federal Reserve began its flurry of interest-rate hikes last spring. That's surprising for a bunch of reasons — but perhaps it shouldn't be.
The benchmark US stock index closed at 4,720 points on Thursday, compared to 4,358 points on March 16 last year, the day before the Fed began its latest hiking cycle. The US central bank went on to raise its benchmark rate from nearly zero to upwards of 5.25% — a 22-year high — in the space of just over 16 months. It has held rates steady since July.
The Fed hiked in response to a historic spike in inflation. Annualized price growth hit a 40-year high of over 9% last summer, far outpacing the central bank's 2% target. Higher rates encourage saving over spending and make borrowing more expensive, which tends to temper overall demand in the economy and slow the pace of price increases.
The rate hikes work in part by squeezing consumers, forcing them to allocate more of their monthly incomes toward the bigger payments due on their credit cards, car loans, mortgages, and other debts. American households have also faced soaring food, fuel, and rent costs, which have stretched their budgets even more.
Between inflation in living expenses and higher debt costs, consumers have been left with less disposable income to spend on goods and services produced by companies, hurting sales. Corporations have also seen their costs and interest payments jump, pinching their profit margins.
A company's shares are generally valued at a multiple to its future earnings, meaning if investors expect its profits to grow less quickly or even shrink, its stock price should come down. Stocks also become relatively less appealing to investors when rates rise, as the returns from safe assets like savings accounts and government bonds increase.
Stocks are valued based on their future cash flows, so if investors see companies struggling to raise prices to protect their profit margins from inflation, and spending more to cover their debt costs each month, they'll reduce their cash-flow forecasts and assign a lower value to their shares today.
Moreover, hiking interest rates can slow the economy so much that it enters a prolonged downturn or recession. Consumers tend to pull back on spending and investors flee to safety when they fear economic pain, providing another reason why stocks tend to suffer when rates increase.
Between elevated inflation, a rapid-fire series of rate hikes, and the increased risk of a recession, there are clear pressures on stocks today. On the other hand, inflation has cooled to below 4% in recent months, the US economy grew strongly in the third quarter, and the Fed signaled this week that it expects to cut rates three times next year. The stock market prices in future expectations, and may reflect investors' optimism that prices are under control, a recession will be avoided, and rates will come down soon.
Ben Inker, the co-head of asset allocation at elite investor Jeremy Grantham's GMO, recently offered two more reasons why stocks are worth more today than a couple years ago. Inflation has boosted the fair value of stocks, because companies produce the goods and services that have climbed in price, he said. The US economy has also grown, and companies tend to grow alongside the wider economy, raising the fair value of stocks once again, he said.
It may be jarring to see the S&P 500 trading 8% higher today, when rates are over 5%, than its level when rates were almost zero. Investors may simply believe the worst of the economic pain is over, and the future is so bright for stocks that they're worth more today.
Federal Reserve on cusp of what some thought impossible: Defeating inflation without steep recession
CHRISTOPHER RUGABER
Fri, December 15, 2023
WASHINGTON (AP) — It was the most painful inflation Americans had experienced since 1981, when “The Dukes of Hazzard” and “The Jeffersons” were topping the TV charts. Yet the Federal Reserve now seems on the verge of defeating it — and without the surge in unemployment and the deep recession that many economists had predicted would accompany it.
Inflation has been falling more or less steadily since peaking in June of last year at 9.1%. And when the Fed's preferred inflation gauge for November is reported next week, it's likely to show that in the past six months, annual inflation actually dipped just below the Fed's target of 2%, economists at UBS estimate.
The cost of goods — such as used cars, furniture and appliances — has fallen for six straight months. Compared with a year ago, goods prices are unchanged, held down by improved global supply chains.
Housing and rental costs, a major driver of inflation, are growing more slowly. Wage growth has cooled, too, though it still tops inflation. Milder wage growth tends to ease pressure on restaurants, hotels and other employers to increase their prices to cover their labor costs.
“I think it’s really good to see the progress that we’re making,” Chair Jerome Powell said at a news conference Wednesday after the Fed's latest policy meeting. “If you look at the ... six-month measures, you see very low numbers.”
On Friday, the Congressional Budget Office, a nonpartisan agency, estimated that inflation will drop to 2.1% by the end of next year.
There will likely be bumps on the road toward getting inflation fully under control, officials have said. Powell insisted that “no one is declaring victory.” And he reiterated that the central bank wants to see further evidence of falling inflation before it would feel confident that it is sustainably headed back to the 2% target.
A news report shows the Federal Reserve's rate decision as Specialist Meric Greenbaum works on the floor of the New York Stock Exchange, Nov. 1, 2023. Confidence is growing among Federal Reserve officials and many economists that high interest rates and healed supply chains will soon defeat inflation.
CHRISTOPHER RUGABER
Fri, December 15, 2023
WASHINGTON (AP) — It was the most painful inflation Americans had experienced since 1981, when “The Dukes of Hazzard” and “The Jeffersons” were topping the TV charts. Yet the Federal Reserve now seems on the verge of defeating it — and without the surge in unemployment and the deep recession that many economists had predicted would accompany it.
Inflation has been falling more or less steadily since peaking in June of last year at 9.1%. And when the Fed's preferred inflation gauge for November is reported next week, it's likely to show that in the past six months, annual inflation actually dipped just below the Fed's target of 2%, economists at UBS estimate.
The cost of goods — such as used cars, furniture and appliances — has fallen for six straight months. Compared with a year ago, goods prices are unchanged, held down by improved global supply chains.
Housing and rental costs, a major driver of inflation, are growing more slowly. Wage growth has cooled, too, though it still tops inflation. Milder wage growth tends to ease pressure on restaurants, hotels and other employers to increase their prices to cover their labor costs.
“I think it’s really good to see the progress that we’re making,” Chair Jerome Powell said at a news conference Wednesday after the Fed's latest policy meeting. “If you look at the ... six-month measures, you see very low numbers.”
On Friday, the Congressional Budget Office, a nonpartisan agency, estimated that inflation will drop to 2.1% by the end of next year.
There will likely be bumps on the road toward getting inflation fully under control, officials have said. Powell insisted that “no one is declaring victory.” And he reiterated that the central bank wants to see further evidence of falling inflation before it would feel confident that it is sustainably headed back to the 2% target.
A news report shows the Federal Reserve's rate decision as Specialist Meric Greenbaum works on the floor of the New York Stock Exchange, Nov. 1, 2023. Confidence is growing among Federal Reserve officials and many economists that high interest rates and healed supply chains will soon defeat inflation.
(AP Photo/Richard Drew, File)
Yet many economists, normally a cautious lot, are now willing to declare that inflation is nearly back under control after two-plus years in which it imposed hardships on millions of American households.
"It appears that inflation has returned to 2%,” said Tim Duy, chief economist at SGH Macroeconomics. “The Fed looks like it has won that battle.”
Prices spikes are also moderating overseas, with both the Bank of England and European Central Bank keeping their benchmark interest rates unchanged this week. Though inflation is still at 4.6% in the United Kingdom, it has fallen to 2.4% in the 20 countries that use the euro currency.
With inflation cooling, Powell said the 19 officials on the Fed's policy setting committee had discussed the prospects for rate cuts at this week's meeting. The officials also projected that the Fed will cut its key interest rate three times next year.
That stance marked a drastic shift from the rate-hiking campaign the Fed began in March 2022. Beginning then, the central bank raised its benchmark rate 11 times, from near zero to roughly 5.4%, its highest level in 22 years, to try to slow borrowing, spending and inflation. The result was much higher costs for mortgages, auto loans, business borrowing and other forms of credit.
Powell's suddenly more optimistic words, and the Fed's rate-cut projections, sent stock market indexes soaring this week. Wall Street traders now foresee a roughly 80% likelihood that the first rate cut will occur when the Fed meets in March, and they are forecasting a total of six cuts in 2024.
On Friday, John Williams, president of the Federal Reserve Bank of New York and a top lieutenant of Powell's, sought to pour some cold water on those expectations. Speaking on CNBC, Williams said it was “premature to be even thinking" about whether to cut rates in March. But he also mentioned that his forecast was for inflation to move down “sustainably” to 2%.
The week's events represented a departure from just two weeks ago, when Powell had said it was “premature” to say whether the Fed had raised its key rate high enough to fully conquer high inflation. On Wednesday, he suggested that the Fed was almost certainly done with rate increases.
Recent data appeared to have helped shift Powell's thinking. On Wednesday, a measure of wholesale prices came in lower than economists had expected. Some of those figures are used to compile the Fed's preferred inflation gauge, which, as a result, is expected to show much lower inflation numbers next week.
Powell said some Fed officials had even updated their economic projections on Wednesday, not long before they were issued, in light of the lower-than-expected wholesale price report.
"The speed at which inflation has fallen has been like an earthquake at the Fed," Duy wrote in a note to clients Wednesday.
And yet in the meantime, the economy keeps growing, defying widespread fears from a year ago that 2023 would bring a recession, a consequence of the much higher borrowing rates the Fed engineered. A report on retail sales Thursday showed that consumers grew their spending last month, likely encouraged by increased discounting that will also lower inflation. Such trends are supporting the growing belief that the economy will achieve an elusive “soft landing,” in which inflation is defeated without an accompanying recession.
“We think the Fed cannot believe its luck: We are back to ‘immaculate disinflation,’ ” Krishna Guha, an economic analyst at investment bank Evercore ISI, wrote in a client note.
Economists credit the Fed's rapid rate hikes for contributing to inflation's decline. In addition, a recovery in global supply chains and a jump in the number of Americans — and recent immigrants — searching for jobs have helped cool the pace of wage growth.
Jon Steinsson, an economics professor at the University of California, Berkeley, said that by aggressively raising their key interest rate in about 15 months — the fastest such pace in four decades — Fed officials kept Americans' inflation expectations largely in check. Expectations can become self-fulfilling: If people expect higher inflation, they often take actions, such as demanding higher wages, that can send prices higher still.
“They played a crucial role,” Steinsson said.
Still, a continued decline in inflation isn't guaranteed. One wild card is rental prices. Real-time measures of new apartment leases show those costs rising much more slowly than they did a year ago. It takes time for that data to flow into the government's figures. In fact, excluding what the government calls “shelter” costs — rents, the cost of homeownership and hotel prices — inflation rose just 1.4% last month from a year earlier.
But Kathy Bostjancic, an economist at Nationwide, said she worries that a shortage of available homes could raise housing costs in the coming years, potentially keeping inflation elevated.
The Fed's rate hikes, Bostjancic said, could actually prolong the shortage. Today's higher mortgage rates may limit home construction while also discouraging current homeowners from selling. Both trends would keep a lid on the supply of homes and keep prices elevated.
Yet Fed officials appear confident in their forecasts that inflation is steadily slowing. In September, 14 of 19 Fed policymakers had said there were risks that inflation could rise faster than they expected. This month, only eight said so.
“Their projections have mostly gone down, and they think the probability that there will be some flare-up of inflation is lower,” said Preston Mui, senior economist at Employ America, an advocacy group.
Yet many economists, normally a cautious lot, are now willing to declare that inflation is nearly back under control after two-plus years in which it imposed hardships on millions of American households.
"It appears that inflation has returned to 2%,” said Tim Duy, chief economist at SGH Macroeconomics. “The Fed looks like it has won that battle.”
Prices spikes are also moderating overseas, with both the Bank of England and European Central Bank keeping their benchmark interest rates unchanged this week. Though inflation is still at 4.6% in the United Kingdom, it has fallen to 2.4% in the 20 countries that use the euro currency.
With inflation cooling, Powell said the 19 officials on the Fed's policy setting committee had discussed the prospects for rate cuts at this week's meeting. The officials also projected that the Fed will cut its key interest rate three times next year.
That stance marked a drastic shift from the rate-hiking campaign the Fed began in March 2022. Beginning then, the central bank raised its benchmark rate 11 times, from near zero to roughly 5.4%, its highest level in 22 years, to try to slow borrowing, spending and inflation. The result was much higher costs for mortgages, auto loans, business borrowing and other forms of credit.
Powell's suddenly more optimistic words, and the Fed's rate-cut projections, sent stock market indexes soaring this week. Wall Street traders now foresee a roughly 80% likelihood that the first rate cut will occur when the Fed meets in March, and they are forecasting a total of six cuts in 2024.
On Friday, John Williams, president of the Federal Reserve Bank of New York and a top lieutenant of Powell's, sought to pour some cold water on those expectations. Speaking on CNBC, Williams said it was “premature to be even thinking" about whether to cut rates in March. But he also mentioned that his forecast was for inflation to move down “sustainably” to 2%.
The week's events represented a departure from just two weeks ago, when Powell had said it was “premature” to say whether the Fed had raised its key rate high enough to fully conquer high inflation. On Wednesday, he suggested that the Fed was almost certainly done with rate increases.
Recent data appeared to have helped shift Powell's thinking. On Wednesday, a measure of wholesale prices came in lower than economists had expected. Some of those figures are used to compile the Fed's preferred inflation gauge, which, as a result, is expected to show much lower inflation numbers next week.
Powell said some Fed officials had even updated their economic projections on Wednesday, not long before they were issued, in light of the lower-than-expected wholesale price report.
"The speed at which inflation has fallen has been like an earthquake at the Fed," Duy wrote in a note to clients Wednesday.
And yet in the meantime, the economy keeps growing, defying widespread fears from a year ago that 2023 would bring a recession, a consequence of the much higher borrowing rates the Fed engineered. A report on retail sales Thursday showed that consumers grew their spending last month, likely encouraged by increased discounting that will also lower inflation. Such trends are supporting the growing belief that the economy will achieve an elusive “soft landing,” in which inflation is defeated without an accompanying recession.
“We think the Fed cannot believe its luck: We are back to ‘immaculate disinflation,’ ” Krishna Guha, an economic analyst at investment bank Evercore ISI, wrote in a client note.
Economists credit the Fed's rapid rate hikes for contributing to inflation's decline. In addition, a recovery in global supply chains and a jump in the number of Americans — and recent immigrants — searching for jobs have helped cool the pace of wage growth.
Jon Steinsson, an economics professor at the University of California, Berkeley, said that by aggressively raising their key interest rate in about 15 months — the fastest such pace in four decades — Fed officials kept Americans' inflation expectations largely in check. Expectations can become self-fulfilling: If people expect higher inflation, they often take actions, such as demanding higher wages, that can send prices higher still.
“They played a crucial role,” Steinsson said.
Still, a continued decline in inflation isn't guaranteed. One wild card is rental prices. Real-time measures of new apartment leases show those costs rising much more slowly than they did a year ago. It takes time for that data to flow into the government's figures. In fact, excluding what the government calls “shelter” costs — rents, the cost of homeownership and hotel prices — inflation rose just 1.4% last month from a year earlier.
But Kathy Bostjancic, an economist at Nationwide, said she worries that a shortage of available homes could raise housing costs in the coming years, potentially keeping inflation elevated.
The Fed's rate hikes, Bostjancic said, could actually prolong the shortage. Today's higher mortgage rates may limit home construction while also discouraging current homeowners from selling. Both trends would keep a lid on the supply of homes and keep prices elevated.
Yet Fed officials appear confident in their forecasts that inflation is steadily slowing. In September, 14 of 19 Fed policymakers had said there were risks that inflation could rise faster than they expected. This month, only eight said so.
“Their projections have mostly gone down, and they think the probability that there will be some flare-up of inflation is lower,” said Preston Mui, senior economist at Employ America, an advocacy group.
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