You’ve probably heard it on the news—we’re “entering the second week of a stock market sell-off.” By midday on Monday, the Dow Jones Industrial Average shed 1,000 points. Such a shift in direction after 12 months of record highs has caught many people off guard. And some investors’ internal alarm bells are ringing.
It’s reasonable at this point to start asking questions: Why is the market performing this way now? Is there a legitimate reason to be worried? What causes a stock market sell-off like this?
In the midst of the market turbulence, today we’ll peel back a few layers and look at several indicators for why the stock market may be behaving the way it is.
3 Economic Precursors to 2018’s Recent Market Changes
1. The Fed may raise interest rates faster than previously expected
Since the economic recovery after the recession of 2009-10, the Federal Reserve has started increasing interest rates. In 2017, we saw rates increase. Analysts expected rates to rise in 2018 as well; however, recent economic data, as well as a new Fed Chairman, caused investors to worry that interest rates may rise faster than previously anticipated.
Since we’re near full employment (according to the U.S. Department of Labor)—January’s 4.1% unemployment rate is the lowest in 17 years—and one estimate of the United States’ GDP growth was up to 5.4% in the first quarter (compared to 3% growth in previous years), the Fed has several indicators that the economy is healthy and may not need as much monetary support.
It’s no surprise that rates would rise after being at record lows; however, expectations about how fast and how much they will rise may have changed.
2. Increased rates mean companies have financial adjustments to make.
When interest rates rise, there isn’t just a market reaction; it has real consequences for how companies operate. Rising interest rates can make it more expensive for large public companies to borrow money.
That added expense often has an impact on the valuation of those companies that end up borrowing at a higher cost. Their bottom lines change, and so do their valuations.
When bond rates are rising, however, that doesn’t mean that the stock market automatically goes into free fall. Learn more about what bond rates rising have meant historically here.
3. The possibility of rising inflation can lead to market hesitance
In historical scenarios, strong GDP growth and rising interest rates have led to increased inflation—i.e. the cost of products and services inches upward. In recent years, inflation has been below 2%, but as the economic environment changes, some investors might be reacting to a possible rise in inflation, even though a slight rise in inflation need not necessarily mean lower returns.
Is a market sell-off a bad thing for investors?
The three points above can help us understand the recent change in market direction, but they don’t necessarily predict anything about the future. The recent turbulence stands as a good reminder that, as investors, we are compensated for taking risk, and that the path to higher returns is seldom a straight line.
In times of increased volatility, investors should be sure to focus on the things they can control, like how much they’re saving and whether they are properly maintaining appropriate levels of risk for their goals.
As we see changes in economic mechanics, as influenced by the Fed or other factors, market reactions in multiple directions are bound to occur. When investing, the key is to remember that holding for long-term growth, riding along market changes up and down is part of how you can reach long-term returns.