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It's getting uglier in stock markets as fears about inflation spark a brutal drop

Traders work on the floor of the New York Stock Exchange on Thursday in New York City. Stocks continued to slump on Monday as the Federal Reserve gears up to raise interest rates in a bid to bring down inflation from 40-year highs. [Spencer Platt / Getty Images]
Traders work on the floor of the New York Stock Exchange on Thursday in New York City. Stocks continued to slump on Monday as the Federal Reserve gears up to raise interest rates in a bid to bring down inflation from 40-year highs.

It's been a brutal start to the year for stocks, and it's bringing a three-year rally in markets to an abrupt halt.

The Dow Jones Industrial Average slumped by more than 700 points on Monday, or a decline of more than 2%, and was headed for a seventh consecutive daily fall.

It was even worse for the S&P 500 and the Nasdaq, which also slumped on Monday and have now both fallen more than 10% each from their record highs — a fall that is known in markets as a correction.

Cryptocurrencies weren't spared from the rout, with Bitcoin down 5% to about $34,000.

Worries about rising tensions in Ukraine, where Russian troops are massed at the borders, contributed to the declines.

But, ultimately, the fears are being driven by the recent surge in inflation to 40-year highs, which will require the Federal Reserve to raise interest rates to cool prices.

Why the outlook is so uncertain

How the Fed goes about doing that is tricky, however.

Higher interest rates will push up borrowing costs for consumers and corporations, and investors are trying to figure out how hard that will hit companies.

Raising rates too much could slow down the economy excessively. Yet raising them too little raises the opposite concern, that they will fail to make too much of a dent on inflation.

At the moment, Wall Street is expecting the Fed to raise interest rates four times this year, potentially starting as early as March. At some point, the Fed is also expected to begin selling assets — including bonds and securities tied to mortgages — it bought during the pandemic to prop up markets and the economy.

In a new research note, economists at Goldman Sachs said they expected the Fed to raise interest rates four times. But they added a note of caution that the Fed could raise interest rates more aggressively if inflation stays high, a process known in markets as policy tightening.

"We see a risk that the FOMC will want to take some tightening action at every meeting until that picture changes," Goldman said in a note, referring to the Federal Open Market Committee (FOMC), the group that takes interest rate decisions at the Fed.

Tech companies are routed

The uncertainty behind interest rates has hit technology companies especially hard, including Meta, Facebook's parent company, and Alphabet, which owns Google.

Shares of technology companies tend to do best in high-growth economies and less so when rates start to climb.

Inflation also eats into future profits, and investors are recalibrating their expectations after technology share prices surged over the past few years.

Of course, it's hard to predict the trajectory of inflation, meaning the uncertainty in stock markets could continue for a while.

Most analysts still expect stock markets to gain this year after rising in each of the previous three.

But gains may not be quite as strong as in recent years. Stocks actually surged during the pandemic as consumers went on a shopping spree, while millions of amateur investors joined markets for the first time.

A lot of what happens will hinge on the progress of inflation, the economy and corporate profits.

The Fed meets on Tuesday and Wednesday, and Fed policymakers are expected to share new details about their plans to raise interest rates, although no meaningful action is expected.

On Friday, the Commerce Department is set to report several economic indicators including consumer spending as well as on inflation.

Meanwhile, a slew of companies including Microsoft and Apple are set to report earnings this week for the last three months of 2021, and investors will be keen to see how corporate profits held up during a period marked by high inflation, supply chain woes and staffing shortages.

Michael Wilson, the chief U.S. equity strategist and chief investment officer at Morgan Stanley, says he is going to pay close attention to how each company has been performing and how executives are handling higher costs.

Like tech companies, stocks that have been driven high by speculation may continue to fall, he said.

"The froth is coming out of an equity market that simply got too extended on valuation," Wilson wrote in a note to clients.

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