The Stock Market In 2022 With Federal Reserve Tightening

Monetary tightening will not be good for the stock market. The Federal Reserve has penciled out ideas about when they will tighten, but it has not written them in ink. Investors and corporate leaders should also consider the many other influences on stock prices, ranging from Covid-19 and domestic spending to global political and economic crises. The new monetary policy, however, will be a large negative influence.

Inflation has been surging, I argued earlier, because of the Fed’s easy money policy. That will certainly change at some point, most likely with small steps beginning in the spring of 2022. The first moves will be gradual and then probably sharper.

Interest rates have a major impact on both stock market prices and real estate values, but causation gets tricky. By themselves, higher interest rates are negative for stock prices for two reasons. First, higher interest rates mean lower present values of future incomes.

If that last statement is obvious, skip this paragraph. A payment to be received in a year is worth less than that same payment in hand right now. If you had the payment now, you could invest it for a return, or you could pay off a debt that is costing you interest. Present value is the term for current value of a future amount. To calculate exactly how much that payment to be received next year is worth today, we divide it by one plus an interest rate. If our interest rate is five percent, we divide the payment to be received in one year by 1.05. If the payment is not to be received in exactly one year, then we compound the interest. The formula is PV = X/[(1+r)^t], where PV denotes the present value, X denotes the future payment, r denotes the interest rate, the ^ symbol shows an exponent, and t denotes the time until the payment will be made. When the interest rate (r) is higher, then the present value is lower.

In addition to lower present values, higher interest rates will slow down economic growth, possibly even to the point of triggering a recession. They first diminish interest-sensitive spending, such as new home construction, automobile purchases and business capital spending. There will then be lower incomes earned by people in these sectors, reducing consumer spending. So if we are thinking of the present value of the future earnings of a corporation, with higher interest rates those earnings will be less, the discount to present value further reduces them.

But sometimes the stock market rises when interest rates rise. In general, interest rates rise when the economy is strong. When the economy is growing fast, both businesses and consumers borrow more and save less, pushing interest rates up. So we cannot say that higher interest rates are bad for the economy, because they are sometimes the result of a strong economy. Similarly, lower interest rates occur when the economy is weak, due to less borrowing and more saving.

In 2022, interest rates are most likely to rise because of Federal Reserve policy, not because the economy is strengthening. Thus, rising interest rates will be negative to business. Corporations that make interest-sensitive products will see lower sales and thus lower profits. The worsening incomes will spread across other sectors. Taken alone, Fed tightening could pull stock prices down.

However, there is more to stock market prices than interest rates. Investor attitudes play a crucial role in the short run, but they are hard to predict. Sticking with fundamental factors, the pace of the Covid-19 pandemic will impact stock prices as it will be a major factor in the overall economy.

Inflation will affect the stock market independently of Fed policy to fight inflation. Higher inflation forces companies to pay higher taxes. In simple terms, they earn a markup on the difference between buying and selling, plus inflationary gains during the time they hold the materials that will eventually be sold. Companies are also forced to allocate more working capital to inventories. A gas station, for example, may earn as much per gallon at the high price, but it will have a much higher dollar value of gas in the storage tanks. More generally, people and businesses will devote more resources to watching prices when buying and selling. Interpreting prices as too high or too low is more difficult. This is like a small tax levied across the entire economy—it adds up pretty fast.

The negative effect of Fed tightening on stock prices may not push the stock market down, if the economy continues to grow. The large rapid gains of recent years could only cool off into small gains. As of this writing bond yields are laughably low, so few will shift from stocks to fixed income for current yield. However, bonds have much less downside risk, and that’s the argument for holding some even when interest rates must be viewed through a microscope.

How bad could the market get? Looking at historical data after the Great Depression, stocks dropped around 40%, plus or minus, when things were really bad. (1939-41, 1973-75, 1999-2002, 2008) There is no guarantee that this is a lower bound on stock market losses, but consider what it would mean in recent terms. A 40% drop in the S&P 500 would take it back to the level of May 2019—and investors would keep the dividends earned over that period. That’s a strong argument for stocks even if their near-term prospects are not spectacular.