Over the last few months, the Federal Reserve has played an increasingly significant role in affecting the global economy and stock market. Unless you’re a new investor, you’ve likely heard the news: “The Fed hiked interest rates by 75 bps. Chairman Powell holds a hawkish stance towards future rate hikes.” Your portfolio has probably suffered, with growth stocks and long-term treasuries losing significant value in 2022. In summary, Fed actions can be a leading indicator of stock market direction. Read on!
What Is the Federal Reserve?
The Federal Reserve, Fed, is the central banking system of the United States. The Fed is made up of 12 regional banks and is in charge of regulating monetary policy, supervising and regulating financial institutions, and maintaining financial stability by acting as a “lender of last resort.”
Federal Open Market Committee, or FOMC, is the Fed’s policymaking body and exerts influence over the economy via a “dual mandate,” which includes:
- Price stability: Over the long term, the Federal Reserve aims to keep the inflation rate at 2%, as measured by annual changes in personal consumption expenditures, or PCE, and consumer price indexes, or CPI.
- Maximum employment: The Fed aims to maintain sustained high employment levels in the economy over the long run.
How Does the Stock Market Respond to Fed Actions?
The Fed has two primary tools for monetary policy, according to Juan Pablo Villamarin, senior investment advisor at Intercontinental Wealth Advisors: “The main tool, and the most widely known by the public, is the fed funds rate (FFR), which is a rate at which banks lend and borrow overnight. He also points out that open-market operations, in which the Fed purchases or sells securities, have been very important.
The FFR affects the economy by making it easier or harder for people to borrow money. The Fed lowered interest rates during the COVID-19 pandemic to boost the economy. By borrowing money cheaply, consumers and businesses were able to invest more and spend more.
After a precipitous drop of over 20%, the S&P 500 rebounded to reach all-time highs just a few months later in a V-shaped recovery. As consumers piled money into the market, many growth stocks posted strong returns. As a result, the market reached high valuations and had large market capitalizations. Additionally, the Fed also engaged in open-market operations and engaged in quantitative easing, in which government bonds and other securities were purchased to stimulate the markets. This provided banks with more liquidity, thereby increasing the money supply.
Let’s fast forward to August 2022. With two consecutive quarters of negative gross domestic product growth, the economy has contracted significantly as a result of a series of 25-, 50- and 75-basis-point hikes implemented to curb inflation. In this way, it has been classified as a recession by technical definition.
Higher FFR means higher borrowing costs for businesses, as they can no longer reinvest capital in growth. Consumers are less able to purchase cars and mortgages at low-interest rates, resulting in lower spending. Additionally, the Fed is tapering asset purchases, thereby reducing economic stimulus. By slowing economic growth, the Fed is trying to combat inflation and bring about price stability. This can create substantial volatility in the markets, as it has done so far in 2022.
How Do Interest Rates Affect Market Sectors and Stocks?
According to Villamarin, interest rate hikes by the Fed result in an increase in capital costs for stocks. When a company’s cost of capital rises, future profits become less valuable, which causes investment and margin spending to decrease.
Stock returns tend to be muted during "restrictive," or rising-interest-rate environments, according to Robert Johnson, chairman, and CEO of Economic Index Associates. Based on a 55-year period, Johnson notes that stocks returned 13.8% in expansive periods and 1.7% in restrictive periods.
While interest rates rise, some sectors of the stock market tend to be more resilient. It is a common mantra that rates are rising, and you should favor one sector and exit another using a sector rotation strategy. A rise in interest rates can benefit companies in the consumer staples, energy, financial, and utility sectors.
Research shows that in tight money environments, it is best to invest in defensive sectors whose firms are less dependent on business cycles. Regardless of whether the economy is strong or weak, people need to consume food, brush their teeth, and heat their homes so they are noncyclical or defensive in nature.
A rise in capital costs would negatively affect those businesses with more cyclical demand, as well as ‘young’ companies that are growing and therefore require more capital to achieve their perceived growth. Stocks that are cyclical in technology, materials, and consumer goods, as well as small-cap stocks, usually fall into this category.
How Should Traders Respond to Fed Actions?
In a nutshell, both traders and markets have a forward-looking approach. Accordingly, traders’ expectations are factored into the current value of various assets based on anticipated future events. A recent example is how markets rallied after Fed Chairman Powell announced a second consecutive 75-basis-point rate hike.
Accordingly, stock market traders and investors expected a large hike in this instance due to his previously hawkish remarks. Powell’s confirmation of the expectation eased the uncertainty, and markets rose. If Powell had announced a 100-point hike, investors would have been shocked and markets would have tanked as investors turned “risk-off.”
According to Brian Huckstep, chief investment officer at Advyzon Investment Management, investors should avoid anticipating and trading around Fed decisions. "Stock market players should not time the markets, since the Fed does not always follow what investors expect, resulting in unexpected surprises," he explains.
Markets often forecast what the Fed will do and ‘front-run’ what will happen, leading much of the impact to occur weeks before the actual rate increase. Nevertheless, Huckstep does recommend the following to stock market traders with shorter time horizons who are less risk tolerant:
- Invest in low-volatility, high-speculative assets like small-cap stocks, growth stocks, and cryptocurrencies.
- Instead of holding long- or intermediate-term bonds, choose short-term ones.
- Sectors such as technology and consumer discretionary have an underweighted position in the stock market.
- Make sure to allocate some funds to cash, but do not hold too much since inflation destroys its value.
It’s important to keep in mind that interest rates will not continue to rise forever for investors with a long-time horizon. As the economy goes through different stages of its cycle, interest rate changes will normalize over time. The best way for long-term investors to deal with Fed rate hikes is to stay invested and endure volatility.
Nvidia gets a big boost from Meta Platforms!
The social media giant ‘META’ formerly known as Facebook (FB.ax), is spending a significant amount of money on one specific area that could benefit the graphics specialist.
Meta Platforms (META) plunged in value following its third-quarter report on Oct. 26, 2022, making it evident that the social media giant is unlikely to emerge from its slump any time soon. Due to shrinking revenue and rising costs, Meta’s margins declined dramatically, causing investors to bury the panic button, and causing the stock to fall by more than 20%. While Meta’s bad report was disappointing, it also contained good news for Nvidia (NVDA.ax). As a result of Meta’s announcement that it would increase capital spending next year, shares of the semiconductor giant rose.
In 2023, Meta Platforms plans to increase its spending on artificial intelligence. On the latest earnings conference call, Meta Platforms CFO Dave Wehner said the company may spend $34 billion to $39 billion on capital expenditures in 2023. According to the midpoint of that range — $36.5 billion –, 2022’s estimated capital expenditures of $32.5 billion are expected to increase by 12%.
According to Wehner, "AI capacity growth will drive substantially all of our capital expenditure growth in 2023." Nvidia's plan to invest more in artificial intelligence (AI) next year boosted its stock price. This is not surprising since Nvidia's chips have played a great part in Meta's AI ambitions, and they have been a driving force behind its success.
Overall, Nvidia’s data center business may benefit from Meta’s plans to increase its investment in AI infrastructure in 2023, especially given recent developments in the sector.
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