Since 13 June, equities within the United States have officially entered a bear market after the S&P 500 – the most popular stock market index in the country – plummeted to 3,749 resulting in 21.3% year-to-date losses for the benchmark.
By definition, stocks enter a bear market when top indexes such as the Dow Jones Industrial Average and the S&P 500 decline by more than 20% either from their peak or on a year-to-date basis.
The valuation of companies across the world has been dramatically slashed since November last year as investors perceived that central banks would be forced to take drastic measures to keep inflation from spiraling out of control in their respective economies.
Market participants got this right as inflation in the United States, for example, came in hot at 8.6% last month, exceeding by 30 basis points both analysts’ estimates for the month and the previous month’s reading.
As a result, the Federal Open Market Committee (FOMC) of the North American central bank decided to increase its benchmark interest rate by 75 basis points to a range between 1.5% and 1.75%, this being the largest single-meeting increase since 1994.
In addition, the institution’s Chairman, Jerome Powell, stated that officials were contemplating a similar increase during their July meeting but reassured investors that they should “not expect moves of this size to be common”
These actions have led many economists to believe that the US is on the brink of entering a recession as corporations will be forced to cut costs by laying off workers to cope with higher financing costs and lower demand from consumers whose budget is being directly eroded by higher prices across the economy.
Bear Market: How Are Equities Affected by Higher Interest Rates?
Interest rates are one of the most important variables that influence the valuation of financial and hard assets as they shape the investors’ expected returns.
The Federal Reserve’s benchmark rate, also known as the federal funds rate, has always been seen as a reference to analyze the situation in which the market is in. Meanwhile, the current yield of 10-year US Treasury Bonds is also used as a guide to determine the so-called risk-free interest rate.
The valuation of equities is typically determined by discounting future cash flows by the applicable expected rate of return for that particular instrument. If the risk-free rate rises, then the rate applicable to equities rises as well and that diminishes the present value of all future cash flows produced by corporations.
In addition, when interest rates increase, other instruments that have a lower risk such as fixed-income securities like bonds tend to become more attractive and that leads to lower inflows for equities.
Finally, higher rates may also cause some firms to become insolvent as they might be unable to refinance their debt as the cost of borrowing has increased to the point that the market may not believe that the corporation will be able to meet its obligations in the future and may refuse to provide additional financing as a result.
What Is Causing Inflation to Spike in the United States?
Inflation at the moment is not being caused by a single issue but by the confluence of multiple negative variables that are pushing prices higher.
The first variable to consider is supply chain constraints caused by COVID-related disruptions. Even though this issue appears to be progressively fading, it may have been the root of the problem a year ago or so as companies struggled to secure enough inventory and were forced to do some panic buying. This led to an increase in the price of raw materials and finished goods across the chain.
Moreover, the war between Russia and Ukraine has also been the cause of higher inflation primarily because it led to higher oil prices due to a reduction in the global supply amid the sanctions imposed on the country presided by Vladimir Putin.
Also read: How to Trade Oil in June 2022
Finally, the Federal Reserve’s highly accommodative monetary policy adopted during the pandemic to stabilize the financial markets results in a flood of liquidity hitting the streets that ultimately led to higher asset prices.
Reports indicate that the Fed printed as much as 22% of all dollars in existence in 2020 alone and that typically has an immediate consequence on the economy, especially at a point when the country’s supply chain is under pressure as more money is chasing fewer goods, which typically leads to higher prices across the board.
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