Comment: US stocks have a tough time on the back of inflation fears

As a result of re-emerging fears about inflation, and what that would mean for Federal Reserve policy, last week was another tough one for US stocks, says Bob Doll, President and Chief Investment Officer of Merrill Lynch Investment Managers…

'The Dow Jones Industrial Average fell 2.1% to 11,114, the S&P 500 Index declined 1.9% to 1,267 and the Nasdaq Composite lost 2.2% to end the week at 2,193. All sectors of the market were down, with energy and materials faring the worst, falling by over 5%.

The two-week decline in stock prices has trimmed the year-to-date gains of the S&P to just over 1% and has moved the Nasdaq into negative territory.

In other market-related news, the biggest headlines last week involved commodities prices, which experienced significant sell-offs. Most commodities, including oil, gold and copper, fell between 5% and 10% for the week. International stock markets, which have outperformed the United States so far this year, were also hit last week, losing an average of about 5%. In contrast to stocks, bonds performed well, with the yield on the 10-year Treasury (which moves in the opposite direction of its price) falling from 5.19% to 5.07% last week.

It is clear that US economic growth is slowing. Consumer sentiment has weakened and the slide in the housing market has continued. We expect consumer-spending levels to move lower as well, as the effects of higher energy prices and higher interest rates continue to work their way through the system. The main question facing markets now is whether the Fed, in working to combat inflation, will tighten too much and risk causing significant damage to economic growth. Markets will remain at risk for as long as investors believe inflation is a problem. Consequently, the Fed faces a tough decision as to when it will pause in its rate-hiking campaign. Additionally, markets have been jittery as a result of the perception that new Fed Chairman Ben Bernanke is dovish when it comes to combating inflation. History has taught us that markets tend to test new Fed chairmen, and Chairman Bernanke is getting a quick education on the
realities of that trend.

In the end, we believe inflation fears will recede fairly quickly once it becomes clear that consumer spending is slowing. Over the past few years, economic surprises generally have been on the positive side, but that has been changing now that higher interest rates have been undermining the key source of consumer confidence - the housing market. Moreover, the stream of positive global economic news in the past six months has been giving way to a mixed picture, and the price spikes in raw materials and energy earlier in the year have dented economic momentum.

Over the longer term, we believe the good news is that a brief economic slowdown this year will ensure that the era of low inflation persists. Long-term low inflation will be critical in sustaining the economic expansion, as well as the bull market in equities and industrial commodities, including energy. In our view, the global economy is in transition from dependence on US consumers to a more balanced set of stimuli. Such a shift is good news for the global economy, but the transition will be bumpy. In this environment, we believe the markets that are most at risk are industrial commodities and precious metals, and related to that, commodity-dependent emerging markets equities. Our long-term view for these asset classes is still positive, as we remain bullish on the global economy and what that will mean for continuing demand for commodities.

However, as we have been saying for several weeks, some short-term profit taking is likely to continue.

Regarding the equity markets, our view is that we are in a correction phase. However, as we have said before, we do not believe this correction signals the beginning of a bear market, as we are not forecasting either an economic or profits recession. Additionally, we believe equity valuations will provide upward support for the markets. We think we are probably about halfway there in terms of price depreciation, although we estimate it will take some time for the rest of the correction to play out. It will likely be at least a matter of weeks, if not a few months, before the weakness ends and the markets resume their upward trend.'

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