This morning, the investment community’s attention turned to the U.S. economy, with the release of another important reading on inflation that was expected to be closely monitored by the Federal Reserve as the lead bank commences its two-day monetary policy meeting today. At 8:30 A.M. (EST), the Labor Department reported that the Producer Price Index (PPI) increased 0.8% in February and was up 10.0% over the 12-month period. Although it showed some slight moderation in recent prices (the consensus expectation was calling for a 0.9% increase), it was still another hot reading on inflation. Meantime, the latest reading on manufacturing activity in the New York area was a dour one, with the Empire State Index down 11.8% last month, the biggest decline since May 2020 and far worse the consensus expectations, which had called for a gain of nearly 6.0%.
Regardless of the new data, our sense is that with the geopolitical turmoil in Eastern Europe and the resultant volatility in the energy market, the Federal Reserve will likely hike the short-term interest rate by 25 basis points, which seems to be already priced into the market. The equity futures, which were moving higher heading into the release of the PPI data, took another step up on the slight moderation in producer (wholesale) prices. It is worth noting that the major averages have historically traded in a tight band in the sessions immediately preceding the Federal Reserve’s monetary policy decisions, but given the current geopolitical turmoil, such can’t be assumed over the next few days.
Meanwhile, yesterday produced a bifurcated performance for equities. The Dow Jones Industrial Average finished relatively flat, while the NASDAQ Composite ended the session deep into negative territory, falling 2%. The main drive of trading was the spike in fixed-income yields; the yield on the benchmark 10-year Treasury bond, which started this month at 1.70%, climbed to 2.14% yesterday on increased concerns about inflation.
Rising bond yields are historically not good for high-growth stocks, and that scenario played out again recently, with technology stocks coming under heavy selling pressure. Higher borrowing costs hurt high-growth stocks, particularly those of companies that are not profitable but which are valued on future earnings potential. When rates rise, future growth is discounted back to present value and is worth less, so investors may not wish to pay as much for those entities—hence the selloff in the technology and small-cap sectors. Energy stocks also fell sharply on the recent pullback in oil and gas quotations, which continues this morning with crude prices down roughly 7% both here and in Europe.
On the other hand, the rising yields have prompted some rotation into value names, many of which tend to perform better in a higher rate environment. Financial stocks got a boost, led by the big banks, as the increased rates boost the earning power of the banks. Likewise, it was a good day for material and industrial stocks, which benefit from lower oil and diesel prices due to the reduced cost to run their operations. Although bond yields have backed up a bit this morning, we still think that value stocks should be given a closer look, especially with the Federal Reserve looking like it is set to embark on a series of interest rate hikes over the course of this year.
– William G. Ferguson
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.
