First released 4-6-2022
Recapping the quarter: Looking back at the first quarter of 2022, January was largely a traditional risk-off month when the SP500 index lost nearly 10% of its value by January 27, driven by inflation worries. The US CPI and core CPI rose 7% and 5.5% respectively in December 2021 from a year ago, and the 10-year US Treasury yield rose to ~1.9% on the news, its highest level since the pandemic. Investors feared the Fed might hike 50 bps at its March meeting rather than 25 bps and announce an early end to its taper program. Among the inflation fears, there was also new concern of growth, should consumers’ wage growth fail to keep up with inflation.
From January 27 to early February, the SP500 recovered some of its loss, mostly attributable to stronger than expected US 21Q4 GDP growth (6.9% annualized despite Omicron vs. the expectation of 5.5%). There were also strong corporate earnings announcements from Apple, Amazon, and Google. At the same time, more Fed officials have come out against a 50 bps increase in March, calling it “not a preferred policy move”. Then we were showered with good news on the labor market – the US added 467,000 jobs in January, and job growth in November and December combined was about 700,000 higher than previously reported. The labor-force participation rate, rose to 62.2% in January, its highest level since in early 2020. Overall, that is a 2-week period when investors leaned towards the view that US economic growth remains intact, despite inflationary pressure.
February 10 brought more inflation news, as the CPI and Core CPI for January 2022 rose 7.5% and 6% from a year ago, vs. 7% and 5.5% in December. The SP500 lost 1.8% of its value on the news. A few days later, the market started to react negatively in anticipation of an imminent invasion of Ukraine by Russia. On Feb 22, Russian troops entered eastern Ukraine. Surprising the consensus view, Russia on Feb 24 launched an unprecedented invasion of Ukraine, striking several key cities including its capital, Kyiv.
Rather surprisingly, the US large cap equity market has engineered a rebound of ~6% since its Feb 23 low, during which, the US Fed raised its fund rate by 25 bps. In fact, most of the positive rebound happened after the Fed raised rates on March 16 and made more hawkish signals by suggesting it may raise rates as many as seven times this year. Fed chairman Jay Powell also commented the Fed would move more aggressively and raise the Fed fund rate by more than 25 bps at a meeting or meetings should it deem appropriate. By mid-March, equity investors had likely ramped up their inflation expectations and preferred the Fed to act more aggressively. The Fed’s latest “whatever it takes” attitude seems to have injected confidence rather than fear in investors’ minds that the Fed’s monetary tightening will be able to bring down inflation without hurting economic growth.
The Russia/Ukraine war has added new fuel to the inflation fire. The 5-Year break even inflation rate is now around ~3.3%, up from ~2.8% in early February. The 10-Year break even inflation rate has moved from ~2.4% to ~2.9% in the same time horizon. Should inflation expectations stay at those levels, the Fed may need to raise its benchmark rate to the 4% to 5% range, which would make 7 rate increases this year necessary including some 50 bps hikes. That said, we still believe part of the current inflation is temporary, and there is a good chance that long term inflation will drop in a couple of years down the road. We are not macro economists, but common sense tells us, in the long run, secular drivers behind the historically low inflation of the past decade will likely still prevail, once the supply chain bottle neck, labor shortage (which is already moderately alleviating), and the war get resolved. Yes, we may get a higher inflation in the next decade than the past decade, but haven’t policy makers and economists long desired 2% inflation?
Rising interest rates are not a death spell to the stock market. In the past 30 years also, there have been four notable Fed tightening experiences.
From February 1994 to February 1995, the Fed raised the effective Fed fund rate from 3.25% to 6%. The SP500 was mostly flat in 1994, and more than doubled in the following three years. The buildup of a robust technology industry was a major driver behind the stock rally, and we believe, the Fed’s tightening policies have likely helped create a nurturing and stable environment for the industry and the economy to grow.
From June 1999 to May 2000, the Fed raised the effective fund rate from 4.75% to 6.50%. The SP500 returned more than 10% in the period as higher rates did little to deter the stock market rally when investors’ irrational exuberance was overflowing. In the following three years, the SP500 did lose nearly half of its value, because investors realized valuations had reached an unsustainable level. Then 9’11 happened in 2001, a black swan event, and the US economy fell into recession.
From June 2004 to June 2006, the Fed raised the effective Fed Fund rate from 1% to 5.25%, and the SP500 appreciated in double digits. The market had a tremendous fall from late 2007 to early 2009, however, because the economy fell into the abyss when the housing bubble burst.
Most recently from March 2017 to December 2018, the Fed raised the fund rate target from 0.75-1.00% to 2.25-2.50%. The magnitude and the pace of the tightening were a lot smaller and slower than prior cycles, and the SP500 returned mid-single digit in the time period. It is worth noting the SP500 declined more than 20% from late September to December 2018, when the Fed appeared hawkish and indicated a willingness to raise rates well above inflation rates. The Fed then had to dial back its 2019 rate hike projection when raising the fund rate for the last time on December 19, 2018.
The economy and the stock market are complicated creatures, with numerous factors constantly interacting with each other. The circumstances and rationales leading to the past four tightening cycles are certainly not quite the same, but the experience does seem to suggest higher interest rates are not stock market assassins by default. The assessment of interest rate decisions should focus on where the policy ends – does it result in a stable and healthy economy, or at least better than the alternative.
The circumstances and rationales leading to the past four tightening cycles are certainly not quite the same, but the experience does seem to suggest higher interest rates are not stock market assassins by default
Inverted yield curve is not fatal. Currently, the 2 Yr and 10 Yr US treasury have comparable yields of ~2.5%, and the yield curve inverted briefly a few times in recent weeks. While many fret over the recessionary signal from an inverted curve, we caution “not too fast” and here is why. 1) When the Fed raises rates, especially aggressively, the short end of the curve naturally rises faster and becomes elevated, which usually causes the 2-10 Yr yield to compress and invert sometimes. 2) Examining the historical precedence, the magnitude and length of an inverted curve matter significantly in terms of being a reliable indicator of a future recession. 3) The Fed’s massive quantitative easing (QE) in the past decade and since 2020 in particular, has likely distorted and suppressed long-term rates. 4) The global nature of today’s economy and bond market likely have helped keep the US long term Treasury yield low, given the long-term government bonds of our European counterparts and Japan have been significantly below those of the US. 5) Despite the current tightening being aggressive, real borrowing costs will likely remain close to 0%, making higher interest rates less accommodative but not necessarily restrictive to economic growth.
While many fret over the recessionary signal from an inverted curve, we caution “not too fast”
While it warrants great caution when the Fed raises rates especially at an aggressive pace, we don’t believe investors should just throw in the towel and announce a recession is inevitable and the stock market is to be roasted. If the real borrowing cost remains low and inflation takes a breather in the coming quarters due to Fed actions and other factors, the US economy could engineer a soft landing or experience only a mild recession. We are optimists.
Required Rate of Return. While we always believe what is good for the economy will eventually be good for the stock market, we understand from an intrinsic value perspective, when everything else is equal, a higher cost of capital will result in lower valuations. When we examine the cost of capital from Applied Finance’s’ Market Derived Discount Rate (MDDR) perspective, it is very interesting to see the real MDDR over the past 24 months have been around 5%, which is comparable to 1994-1995, 50-100 bps below 1999-2000, and approximately 100 bps higher than the 2004-2006 period. This “healthy” discount rate was prevalent in the past years despite the 10 Yr US Treasury yield and inflation expectations were at very low levels. Investors demanded a lofty Equity Risk Premium (ERP) to invest in the stock market while the risk free rate was very low. We shall see what kind of required rate of return will investors demand in the months and years ahead, but as of right now, we are skeptical the real discount rate will rise significantly from current levels. The real MDDR was mostly above 7% during the 80s, when both long-term US Treasury yield and the ERP were at elevated levels. We don’t believe the current economic and geo-political environment resemble that of the 70s/80s. With the SP500 fluctuating between low single digits to mid double digits decline, market participants seem to be debating whether the real discount rate will increase 50 or 100 bps. If investors are confident the Fed will and can fight inflation without hurting growth too much, the US equity market could remain resilient, as the ERP could trend lower.
We shall see what kind of required rate of return will investors demand in the months and years ahead, but as of right now, we are skeptical the real discount rate will rise significantly from current levels.
Macro backdrop. We entered 2022 feeling confident about the economic backdrop for the US equity market. Russia’s invasion in Ukraine again proved the old Yogi Berra saying – “Forecasting is hard, especially about the future”. The war has created the risks of a new recession especially for Europe, by curbing European exports, straining supply chains and driving up energy and commodity prices for households and the European region’s important manufacturing sectors. While GDP forecasts are all over the place, the Fed now sees the US economy expanding by 2.8% this year, down from the 4% it had predicted in December. 2023 and 2024 GDP growth outlook remain unchanged at 2.2 and 2% respectively. Interesting enough, since December 31, the consensus 2022 EPS estimate for the SP500 has risen to $227.80 from $223.43, according to FactSet. 2023 EPS forecast was also a strong $249.79 for the index, implying a 9.6% growth over 2022.
Valuation and Wealth Creation is Timeless™.
2022 market sentiment will continue to be dominated by rising rates, and our research suggests that irrespective of sensitivity to interest rates, undervalued companies outperform while overvalued companies underperform, from an Applied Finance’ intrinsic value perspective. As explained in our 21Q4 Quarterly Review, we developed a simple proxy for interest rate sensitivity by segmenting a company’s value into the cash from existing investments and future growth. All things equal, the more future cash flow a company needs to justify its value, the more sensitive its value is to changes in interest rates.
Returns to Portfolios Formed on Economic Margin® Valuation and I-Rate Sensitivity
*Applied Finance Database
As a long only Large Cap strategy, the Valuation 50 will continue to focus on owning undervalued stocks in its SP500 universe, while maintaining broad sector exposure and industry diversification. In addition, we stress the importance of having a long-term investment horizon. Great management teams and great companies figure out what to do in both unfavorable and favorable environments. Great companies are long duration assets because of their staying power and equity investing to us is all about long duration investing. Always, we rely on a valuation buffer and wealth creating management teams as best risk management tools and right now, they will be our best defense against rising inflation and a higher cost of capital.
Great management teams and great companies figure out what to do in both unfavorable and favorable environments.
Regarding the Russia/Ukraine war, we are not sure what the end game is in the near term. Ceasefire negotiations are on-going, but they don’t seem very serious. Further down the road, however, we believe there are some long-term positives for Europe, despite this unfortunate war. The European Commission on March 8 outlined ambitious proposals to make Europe independent from Russian fossil fuels well before 2030. Currently Russian gas represents 40% of its gas supply and 27% of the EU’s crude oil imports. Rest assured significant amounts of public spending and government budgets will be directed to building out the infrastructure for energy production and transportation. In addition, military spending will be bolstered, which could help mitigate the negative impact on GDP for years to come. Achieving energy independence is undoubtedly a big long-term positive for Europe.