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How investors might react as the Fed looks to hike rates
Thursday 27 Jan 2022 Author: Russ Mould

Well, that didn’t take long. The US Federal Reserve began to pump less quantitative easing (QE) into the financial system in November and the stock market’s wheels have already started to wobble after barely two months of less cheap money, let alone any move to withdraw it.

Investors can therefore be forgiven for starting to ask themselves how much the US Federal Reserve can do to tighten monetary policy before it either puts the brakes on the economy, breaks the stock market or both. In a worst case, the answer might be not very far at all.

TIGHTENING UP

Recent precedents for tighter monetary policy (or even simply, less loose, less accommodative policy) are enough to give investors pause for thought:

In 2013, financial markets rebelled at the very talk of tighter policy and the so-called ‘taper tantrum’ persuaded the Fed to back off.

Between December 2015 and December 2018, under Janet Yellen and her successor and current incumbent Jerome Powell, the Fed raised rates from 0.25% to 2.50%.

It also shrank its balance sheet by $700 billion, or some 17%, between 2017 and 2019. But it then stopped as the US economy began to slow, and signs of stress began to show in the US interbank funding markets in autumn 2019. As a result, the Fed’s balance sheet had started to grow again several months before the pandemic prompted fresh interest rate cuts and more QE in the spring of 2020.

Tighter policy has four possible implications for company valuations and  share prices:

Higher interest rates may mean an economic slowdown, again because there is so much more debt in the system. As the old saying goes, economic upturns don’t die of old age, they are murdered in their beds by the US Federal Reserve. In addition, consumers’ ability to consume will be crimped if inflation outstrips wage growth and their incomes start to stagnate or fall in real terms.

Higher rates reflect inflation, and faster (nominal) GDP means investors do not have to pay a premium for long-term future growth (for secular growth names like technology and biotechnology) when potentially faster, near-term cyclical growth (‘value’) can be bought for much lower multiples (even if it comes from oils, miners, banks).

Inflation can eat away at corporate margins and profits. Right now, they stand both at pretty much record highs, as do valuations, at least in the US, based on ratios such as market cap-to-GDP and professor Robert Shiller’s cyclically-adjusted price-to-earnings ratio. If earnings start falling, valuations could do so, too, if confidence wobbles. Instead of the double-whammy that helps super charge the upside, as investors pay higher multiples for higher earnings to give ever-higher share prices, markets see the opposite: earnings fall, investors pay lower multiples for lower earnings and share prices fall faster.

Higher interest rates mean analysts and investors deploy an increased discount rate in their discounted cash flow models to calculate the net present value or NPV of future cash flows from long-term growth stocks. A higher discount rate means lower NPV. A lower NPV means a lower theoretical value of the stock and that means a lower share price.

All four are clearly worrying previously rampant financial markets but that in theory should not be the concern of the US Federal Reserve, or indeed any central bank. Their job is to keep inflation on the straight and narrow, to ensure it does not destroy wealth and prosperity and imbalance the economy.

But a decade and more of zero interest rates and QE – unintentionally or intentionally (judging by a string of speeches from former Fed chair Ben S. Bernanke dating back to at least 2003) – have persuaded or forced investors to take ever-increasing amounts of risk to get a return on their money.

Central banks are presumably concerned that having tried to create a wealth effect by stoking asset prices, the opposite effect could now kick in. US household wealth stands at a record high relative to GDP, thanks to booming stock and house prices. If that goes into reverse, the hit to confidence and consumers ability and willingness to consume could be considerable.

Central banks may therefore be stuck between a rock and a hard place. They will want to control inflation on one side. But their ability to jack up interest rates may be constrained by record debts and concerns about the economy, employment (and financial markets’ stability) on the other. If forced to choose, this column reckons they will take their chances with inflation and even cut interest rates and resume QE if the going gets tough.

HISTORY LESSON

Investors will then have choices to make too.

If the low-growth, low-inflation, low-rates of the last decade is replaced by higher inflation, higher nominal growth and higher rates it would be logical to expect the outperformers of the last decade (long-duration assets, bonds, tech and growth equities) to struggle and the underperformers of the last decade (short-duration assets, commodities and cyclical, value equities) to have a chance of a return to favour.

A change in market leadership does not necessarily signify a collapse, even if it raises the stakes, but more volatility seems likely unless oil and gas prices start to retreat and cut central bankers, politicians and the public some slack.

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