U.S. equity markets posted their worst weekly performance since March of 2020 last week as market participants continue to grapple with the change in direction of policy from the Federal Reserve towards tightening financial conditions. The resurgence in geopolitical tensions, including the escalations with Russia on the Ukraine border, has also caused some investor skittishness. For the week, the S&P 500 and Dow Jones closed out a third straight week of losses, down 5.7% and 4.6% respectively, while the tech-heavy Nasdaq tumbled even further with a 7.6% loss and is now down almost 15% below its high set in November. Meanwhile, the rise in long-term interest rates has stalled out a bit after tearing higher to start the year. The 10-year Treasury yield, which touched as high as 1.87% last week, has fallen back to 1.75% as investors are waiting intently for an update from the Federal Reserve following the completion of their monthly meeting on Wednesday.

In 2021, equities and real assets like real estate and commodities provided exceptional returns for investment portfolios that helped offset the pains of rising inflation. While much of the fundamental support for risk assets remains intact, the persistent and broadening impact of inflation has increased the pressure on central banks to accelerate plans to tighten financial conditions and withdraw excess liquidity. As a result, the recent market drawdown has blown off some of the excess froth that built up in asset markets over the past few years. The selling pressure has been especially severe in some of the more speculative areas of financial markets, like SPACs (Special Purpose Acquisition Companies) and cryptocurrencies.

Rate hike cycles in and of themselves are not necessarily a negative omen for future market returns, particularly in the early stages when central banks are responding to strong economic growth and inflation as they are today. In fact, the S&P 500 index has historically risen at an average annualized pace of 9% during the last 12 rate hike cycles going back to the 1950s and delivered positive returns in 11 of those instances, according to Bloomberg.

The real risk from a policy shift is that continued upside surprises in inflation could force more drastic measures from the Fed, threatening to stifle economic growth. Today, markets have dialed in on expectations for a 0.25% quarterly pace to rate hikes beginning in March and a gradual reduction of the Fed balance sheet later this year. As long as actual policy outcomes align with those expectations, volatility may begin to ease back from the current spike. While the Fed has a difficult job ahead in removing accommodation while the economy naturally slows from fading stimulus-fueled demand, our team doesn’t believe at this time that the Federal Reserve will react with sharp and unexpected rate hikes and will instead continue to chart a gradual and extensively communicated path to tightening.

From a fundamental perspective, earnings growth in the year ahead is cooling compared to last year’s astounding growth but earnings are still expected to remain robust. While the S&P 500 is down almost 8% so far in 2022, earnings growth expectations in aggregate have remained steady with consensus forecasts guiding for almost 9% earnings growth for the index constituents in 2022, according to FactSet.

Our team will be gauging two key items on the earnings front as fourth quarter earnings season kicks into full-gear this week. One is the extent to which demand has been pulled forward over the past two years in certain areas of the economy. A prime example of this was last week’s earnings report from streaming giant Netflix, who was a major beneficiary of pandemic lockdowns as its subscriber base surged in 2020. However, the recent trends in new subscriber growth in the fourth quarter of 2021 fell well short of expectations, leading to a 22% sell-off in the stock.

The other area of scrutiny will be on profit margins. Margins have remained surprisingly buoyant since the initial economic recovery from the pandemic but there are signs that sustained wage pressures and other supply chain issues may begin to weigh on margins for more businesses, particularly where sales growth is moderating. Market reactions are unlikely to be very forgiving for companies that fall short of expectations or give disappointing forward-looking guidance. However, drawdowns based on short-term earnings misses or on broad market concerns may provide an expanding opportunity set of high-quality businesses selling at attractive prices for long-term investors.

Given the shift away from accommodative policy that has been a key tailwind for asset prices for years, financial markets may be in for a choppier ride ahead as opposed to the smooth upward trajectory of the recent past. While stock market volatility is unnerving, our team at First Merchants Private Wealth Advisors is here to help you cut through the headline noise and make financial decisions that are best aligned to your long-term goals. We won’t hesitate to act on reducing or shifting risk exposure on behalf of our clients if the fundamental outlook deteriorates. As always, we welcome your comments and are always available for consultation if you have more questions.