The Main Event: Cure Vs. Disease
– “What’s your prediction for the fight, then?”
– “Yes, prediction.”
Clubber Lang, pre-fight interview, “Rocky III”
Recent U.S. Federal Reserve comments regarding the central bank’s resolve in fighting inflation have become more frequent and consistent. In his August 26, 2022 comments from Jackson Hole, Wyo., Jerome Powell said:
While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.
This description of the impact of continued interest rate increases has both stock and bond markets on edge. At the core of the matter, the Federal Reserve is attempting to regain its credibility, after keeping monetary policy too easy for too long and spurring lofty stock market valuations and a macro backdrop of inflation. A backdrop that it is fighting today. Many of the questions surrounding the Fed now are regarding how far their campaign to raise interest rates to quell inflation might go. To begin to gauge this, we would like to introduce to you the CME Fed Watch Tool.
Real Time Market Probability, CME Style
The CME Fed Watch Tool is a neat way to see in real time what the interest rate markets are saying the Fed will do at future meetings. What we find most interesting is its ability to track – over time – how the probabilities of future moves have changed. Below is an example; this snapshot was taken on September 21, 2022 and was looking ahead to the December 13 year-end Fed meeting. In the table below the chart, we can see the progression of what the market thinks is going to happen. On August 19 (far right column), the month before this moment in time was captured, the probabilities were centered around 3.00% to 3.50% as to where the Fed would have interest rates by December. Then, as time passed and the Fed’s tone became more stern (i.e., the “pain” comments made on August 26), we can see how the probability for year-end rates are now centered around 4.00% to 4.50%, indicating what the market currently believes that the Fed is communicating it is going to do.
The Impact of Higher Interest Rates on Stocks
“Some people see the glass half full. Others see it half empty. I see a glass that’s twice as big as it needs to be.”
– Comedian George Carlin
Now that we have established that the interest rate market believes the Fed will continue to raise rates, we want to turn our attention to the impact of higher rates on stocks. To date, the price declines in the stock market have come from price to earnings (P/E) multiple shrinking or multiple compression. Said another way, the prices of stocks have adjusted in response to higher interest rates as the dominant macro backdrop has been inflationary. Conversely, when the dominant macro backdrop is deflationary, the price declines are more a result of earnings contraction as the ensuing recession can be quite deep.
Higher interest rates have affected Growth stocks significantly more than their Value counterparts. As of this writing, VTV, the ETF that tracks the Russell 1000 Value Index, is down 12.5% for 2022, while VUG, the ETF that tracks the Russell 1000 Growth Index, is down 34.7% for 2022. This begs the question: Why the difference? In our opinion, the Value indices are dominated by sectors and companies that have steadier earnings streams – irrespective of macro backdrop – and have pricing power or the ability to pass price increases on to the end customer. These sectors include Energy, Consumer Staples, and Healthcare. Growth, on the other hand, is dominated by companies that – as the index name suggests – are growing their topline rapidly and, perhaps, do not have the pricing power to pass on higher prices, presented by an inflationary environment, to end customers. These include sectors such as Technology, Communication Services, and Consumer Discretionary.
Here is the crossroads at which we find ourselves in the marketplace now: If a recession is nigh, the E (Earnings in the P/E multiple) may be at risk of shrinking. If this is the case, we may find that, if prices have declined sufficiently and earnings follow lower, you may have the P/E multiple expand as the denominator has shrunk enough to make the overall P/E rise.
The Federal Reserve has a commitment to continue interest rate increases to fight inflation and the interest rate markets believe their comments about the future, with rates heading higher. Nonetheless, we continue to own quality companies whose fundamentals – in terms of profitability and pricing power – remain intact. Leaning portfolios towards Value over Growth, and U.S. over International in equity. For bonds, we continue to be shorter than the U.S. Aggregate index duration.