December 19, 2021

Federal Reverse

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Bottom Line:


The Fed clarified their intentions this week by committing to halt Quantitative Easing by March and signaling three rate increases thereafter in 2022. Markets reacted quite favorably to the clarity on Wednesday and then somewhat wildly later in the week as the algorithms adjusted. Why? Rate hikes alone haven’t historically meant market declines, but they have meant market leadership changes. Now that the Fed has spoken, it is time for investors to re-evaluate their rosters for 2022.


The Full Story:


The Federal Reserve met this week and revealed their plan to reverse monetary policy in 2022. With inflation running high and unemployment running low, the shift was widely expected and appropriate. Markets reacted positively to the announcement and then negatively, then positively, and then negatively and positively again. With so many gyrations before and after the Fed meeting, how should investors prepare for 2022?


What the Fed Said


The Fed will increase their asset purchase reductions from $30 billion to $15 billion a month, effectively scheduling the termination of their COVID Quantitative Easing program this March. This means they will ONLY add $130 billion MORE in new money before stopping the printing press. When questioned on why they should bother to print at all, Powell gave an “easy does it” response.


The Fed signaled their intent to increase interest rates .75% next year. Rate increases will begin once QE has ended. Since they tend to adjust rates at their quarterly meetings when they release projections, that would imply .25% in June, .25% in September and .25% in December. It is somewhat futile to look beyond that horizon given COVID and inflation uncertainties. Remember, without corresponding stimulus response, COVID is deflationary. Furthermore, the waning of existing stimulus is also deflationary. Recall also that our real potential GDP growth rate (productivity + workforce growth) sits below 2% due to demographic drags, which is also deflationary:


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Therefore, while inflation has moved the Fed to act, it has done so conversationally (“we will keep printing money until March, then we will likely raise rates .75% after that”). That is hawkish in tone but dovish in practice. Furthermore, Powell mentioned at the press conference that they didn’t want to “upset” markets with their movements, implying that if the market boos they may rescript. I believe that they still believe the current inflation numbers will descend. That may mean fewer rate increases than projected. The surprise of 2022 may be the under on inflation, and the Fed’s response to it.


Should you Sell?


While I don’t think the Fed will raise rates up to its guess of 2.5% or so over the next 36 months, a rising rate regime has started. Fortunately, the Fed only raises rates to prevent the economy from “overheating.” When they projected rate hikes for next year, they also increased their real GDP growth expectations for 2022 from 3.8% to 4%. They also estimate 2022 inflation at 2.6%, making non-inflation adjusted or “nominal” GDP growth nearly 7%. This is a domestic revenue opportunity for corporations. Correspondingly, according to FactSet, S&P 500 companies should grow revenues by 7.5% next year and earnings should grow by 9.2%. Even if rates tick up slightly and crimp valuations, the earnings power should win out. This is not an unusual outcome. In fact, initial rate hikes have better performance track records than rate cuts:


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Therefore, investors should not sell in anticipation of rate hikes alone. However, they might want to reconsider what they own. Recall that higher P/E stocks have lower “earnings” yields (i.e., a P/E of 50 is the same as an earnings yield of 2%). As yields rise, the relative value of stock earnings yields declines. Therefore, high P/E stocks should be at a disadvantage to low P/E stocks when rates rise. Markets have sold off over the last month in anticipation of a hawkish pivot from the Fed. Let’s test our theory by comparing returns across different equity classes and valuation levels over the period:


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In short, our first four contestants with an average P/E of 12.5x suffered 3.87% declines, while our bottom four contestants with an average P/E of 23.5x suffered 10.02% declines. Theory proven! Therefore, while rising rates (on their own) shouldn’t kill this bull market, investors may need to get more selective on which stocks they ride.


Have a great Sunday!



David S. Waddell 
CEO, Chief Investment Strategist




Sources: Hulbert Ratings, Morningstar, FRED



David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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