On my first day on the trading floor of the Chicago Board Options Exchange, I quickly learned one simple fact — markets are designed to react, and negative reactions are simply a part of that fact.
But over the past year-and-a-half, we really haven’t had too many negative reactions. Sure, we’ve had some market declines, but nothing that gave us any pause for concern. The stock market appeared to be on auto-pilot, pushing from one new all-time-high to the next.
And then the stock market fell, and hard. On Monday, Feb. 5, the Dow Jones Industrial Average fell 4.6 percent, losing 1,175 points, to close at 24,345. It was the largest one-day point decline in the Dow’s 122-year history. During the day, the Dow had fallen as much as 1,600 points. Monday’s decline capped an 8.5 percent drop from its all-time-high of 26,616, set just days earlier on Jan. 26.
Interestingly, Monday’s fallout doesn’t compare to the punishing losses of Black Monday in 1987, where the Dow fell 508 points, losing a massive 22.6 percent of its value in a single day. But it is the largest decline since the Dow lost 4.8 percent over two days in June 2016 from the Brexit vote, which triggered the United Kingdom's voluntary departure from the European Union. This has investors searching for answers. So, what exactly is causing the turmoil?
The short answer might be we were simply due for a pullback from the recent historic run-up in stock prices. In 2017, the Dow gained 25.1 percent, more than three times its 97-year annual average of around 8 percent. Within the first 26 days of this year, the Dow had already surged 7.7 percent. In just under 13 months, the S&P 500 gained 28.3 percent while the tech-heavy NASDAQ increased a whopping 39.4 percent. Even the most ardent of capitalists understands this break-neck pace of stock market gains was hardly sustainable.
But a more complex explanation is the concern of the return of inflation, and more importantly, what it means for interest rates. As our economy continues to surge, the financial markets fear it will start driving prices for goods and services higher. In the past two weeks, inflation fears were stoked by economic data that confirmed a spike in consumer and business spending, an exceptionally strong U.S. labor market and the return of rising wages. For nearly a decade, average annual wage growth was a very tepid 2.2 percent. But in January, annualized wage growth shot up to 2.9 percent, its fastest pace in eight years.
To prevent prices from skyrocketing and the economy from overheating, the Federal Reserve implements hikes to the benchmark fed funds rate, upon which short-term debt is often based. As part of its rate hike agenda, the Fed had planned three 0.25 percent rate hikes this year, with two more in 2019. However, the prospects of rising inflation have the markets concerned of a potential fourth rate hike this year.
With additional rate hikes come additional risks. First, rising interest rates constrict economic growth, as higher borrowing costs on short-term debt restrict consumer and business spending. Second, the more hikes there are, the greater the chance something can go wrong. If the Fed raises rates too fast or too slow, it can severely harm the current tempo of economic growth. Also, rising interest rates pull funds from the stock market, as higher rates on bonds now offer investors higher returns and safety.
Understandably, investors have been left questioning the future outlook for the stock market. However, the fundamentals for the stock market do remain strong. Economic growth is robust, led by continued strength in consumer and business spending. The labor market is strong, averaging 183,000 new jobs a month. The unemployment rate is at 4.1 percent, a 17-year low, and is expected to further decline to 3.9 percent for the next two years. Corporate earnings continue to grow amid a strengthening global economy. Finally, the recently passed corporate and personal tax cuts are expected to further boost economic growth.
But a solid foundation for stocks doesn’t inherently mean we’ll see a return of the 20-30 percent annual growth of 2017, or that there won’t be further pullbacks. The impact of higher inflation and rising interest rates does pose challenges, as we’ve clearly seen. Yes, we may experience more volatility as the markets look to digest the latest economic and inflation data. But perspective, and a deep breath, can go a long way in navigating these uncertainties.