Investment Update: Time to Taper, but Equities may still Thrive

Jeff Mortimer, CFA, Director of Investment Strategy

Although inflation is going up, history shows that it's not necessarily something to fear, as long as it stays in a 2-4% range.

I don’t know about you, but I am amazed at how accurate GPS is at predicting my arrival time when I start a long trip. The software assesses traffic patterns, which enables it to estimate how long I will be on the road.

The equity market seems to have done the same thing when evaluating the most recent change to Federal Reserve (Fed) policy and their announcement to begin to taper their purchases of bonds, later this month. In fact, this move seems to have been so well telegraphed by the Fed that following Chairman Jerome Powell’s press conference, the U.S. Treasury yield curve steepened, and U.S. equities rallied, signaling that markets were less concerned that the central bank will tighten too quickly. And since that day, yields have moved lower across the curve, despite a very strong jobs report.

Let’s take a deeper dive into Fed policy, where inflation may go from here and what it may mean for equity markets going forward.

Don’t Fight the Fed?

The general meaning of this mantra is that you should invest in stocks when interest rates are low or when the Fed is stimulating the economy through easy monetary policy. The opposite is also true: reduce exposure to stocks when the Fed is raising rates or when it deems inflation to be too high.

While this mantra has generally served investors well over time, it hasn’t worked particularly well over the last 20 years. As Exhibit 1 indicates, during periods from 2000 through 2020, when the Fed began raising short-term interest rates, the stock market continued to do quite well, sometimes moving higher with interest rates for years. The market seemed to be interpreting rising rates as a sign that the economy was growing, and that the Fed was able to raise interest rates in what it considered to be a continuous low inflationary environment.

Exhibit 1: S&P 500 Performance During Periods of Fed Funds Rate Hikes (2000-2020) 

S&P performance chart

“Don’t fight the Fed” did work quite well from 1960 to 2000. But it seems to have worked better back then because inflation was much more of a problem, especially in the first 20 years. In fact, most of the factors that caused the Fed to act so aggressively in the past are not in place today. For example, there were oil price shocks, strong unionization of the workforce, lack of imports and lack of competition putting upward pressure on prices. That led to wage price spirals, as workers demanded higher pay in order to afford goods. During that period, the Fed also raised rates more quickly than they have in recent years, and many times pushed the economy into recession to combat rapidly rising prices. In fact, the phrase “three steps and a stumble” got its meaning at that time, as equity markets tended to struggle after the third rate hike by the Fed.

It should be noted that the Fed has only announced tapering at its November meeting. The central bank’s current plan is to finish tapering before raising interest rates, which would put the earliest rate hike in the second half of 2022. However, Powell did stress that the timing of lift-off will depend on the path of the economy.

A New Regime?

For most of the last decade, inflation has run between zero and 2% annually, as measured by the most common inflationary measure, the Consumer Price Index (CPI). Under this regime, equity markets have done quite well, as multiples (the price investors are willing to pay for future earnings) have historically held an inverse relationship to the level of inflation and interest rates. When inflation and interest rates were low between 2010 and 2020, companies generated strong earnings, allowing equities to march generally higher during that period.

Today many investors wonder what will happen to equity markets if inflation moves up into a persistently higher band of 2% to 4% over the foreseeable future. History offers some answers: Throughout most of my career, inflation has run in a  2% to 4% band – and equity markets did quite well under that regime. This leads me to believe that markets would continue to perform well if future inflation were to settle at this higher yet manageable level.

In fact, equities may even enjoy a bit of inflation. This would allow companies to raise prices slightly, pay modest annual wage increases and grow earnings, which are expressed in nominal dollars. In fact, fearing higher inflation may be the wrong emotion. We may want to root for modestly higher inflation given the history of very strong equity performance when inflation runs between 2% and 4%. Exhibit 2 illustrates this point. It shows that actual inflation must move persistently above 6% in order to have a real material impact on earnings multiples.

October's headline CPI rose 6.2% from a year ago, a 30-year high, the fastest 12-month pace since 1990, and the fifth straight month of inflation above 5%. Even so, we believe inflation may settle in at a new normal rate of 3% to 4%, slightly higher than it has been in the past decade. Consistent with the Fed’s view, we continue to regard the current period of elevated inflation as temporary. While cost pressures resulting from supply-chain bottlenecks have likely peaked and should abate over the next six months or so, we continue to monitor wage inflation resulting from a shortage of workers. Even so, we expect disinflationary factors such as technology, productivity and demographics will continue to constrain inflation from moving much higher than that level.

Exhibit 2: Low Inflation Supportive of Current Valuations 

Chart showing Average S&P 500 LTM Price to Earnings

Summary

The Fed has signaled a change in direction. Both the bond and equity markets seem to be taking this in their stride, as we expected. The Fed has been transparent about its plans and, so far, it has not disappointed markets. We continue to believe that this spike in inflation will prove to be temporary, although we do admit that “temporary” may be a bit longer than initially estimated. But, as long as inflation remains well behaved, the shift in Fed policy should not have a material impact on stock prices or multiples going forward. Fixed income markets should also remain well behaved, with rates rising over time, but gradually.

Since the onset of the pandemic, markets have done a good job at predicting economic growth 12 to 18 months forward. In fact, they have done a better job than most economists at predicting renewed global demand, strong corporate earnings and a new normal coming out of COVID-19. As I write this update, we are once again at new all-time highs in the major U.S. equity averages. Even as the Fed begins to change its stripes slowly, I believe the stock and bond markets will serve as a reliable GPS and are signaling not to fear a little inflation.

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