Preparing for the great normalisation
The last couple of years can be described as anything but normal.
Since early 2020, global government responses to the worldwide pandemic have ranged from extreme lockdowns to variable reopening policies, while massive monetary and fiscal stimulus has resulted in rising consumer prices and extreme market volatility.
Flooding the economic system with free money helped equity markets soar far above their pre-pandemic levels but has also led to massive labour dislocations, supply chain disruptions and high inflation. However, free money policies are about to end.
Central banks have made it clear that the way forward is going to look quite different. In recent weeks, the UK, Canada and other countries have hiked interest rates and the US Federal Reserve has taken a more hawkish stance by doubling its bond tapering programme.
The tapering process is designed to wind down the Fed’s systematic bond and mortgage securities purchases, which have been keeping a lid on longer-term yields. Moreover, the Fed appears on track to raise US interest rates next month.
While this sudden policy reversal may seem dramatic, these tactics are simply aimed at normalising the economic environment following the extreme policies of the recent past.
For example, the current Federal Reserve forecast is for the Fed Funds rate to rise from near zero to 0.75 per cent by the end of 2022 and between 1.5 per cent and 1.75 per cent by the end of 2023.
If the Fed achieves these objectives, that just makes the base rate equal to the average funds rate of about 1.5 per cent before the onset of the pandemic in early 2020.
Equity markets sold off sharply last month in reaction to these less friendly monetary policies. While investors are not usually pleased with sharp drawdowns, market corrections have always been a part of investing in equities and other riskier assets.
Greater volatility is the price we pay for superior long-term returns.
Alongside the broader normalisation of interest rates, investors are seeing a normalisation of equity valuations. When rates were set to zero in 2020, equities mathematically deserved high valuations. This is so because the present value of any asset, can be viewed as the current value of future cash flows discounted at the prevailing interest rate. The lower the current interest rate, the higher the expected valuations and vice versa.
Before the pandemic, the S&P 500 was trading at a price-earnings (P/E) ratio of about 22 times trailing (2019) earnings and 19.5 times forward estimated earnings. Then, we had some wild market swings during 2020 as the economy quickly dipped into recession but just as swiftly recovered.
Last year, valuations rose to as high as 32 times trailing earnings and 23 times forward earnings driven by both a stronger economy and ultra-low interest rates. Speculation exploded in 2021 on the back of easy money as witnessed by the parabolic rise in high-risk asset prices including cryptocurrencies, SPAC’s and so-called meme stocks.
The tables turned during the “Powell pivot” last December when the Fed chairman indicated he would begin raising interest rates this spring, US Treasury bond rates have risen across the curve and P/Es in the broader markets have fallen. In fact, the current yield structure of the interest rate curve appears to be pricing in seven quarter point interest rate increases over the next two years.
Just as the bond market has factored in higher interest rates, so have the equity markets. The current trailing price-earnings ratio of the S&P 500 stands at 24 times, while the forward price-earnings ratio is approximately 20.4 times, about 2.5 turns below forward P/E before the Powell pivot.
The normalisation of market valuations belies a more significant rotation occurring among investment styles and sector. For example, growth stocks have dramatically underperformed value stocks this year. The Russell 1000 value index has fallen just 0.51 per cent versus the Russell 1000 growth index falling 8.01 per cent as of this writing, representing 7.5 per cent of outperformance.
In general, value stocks provide more positive cash flows and dividends sooner than growth stocks and thus may be considered “shorter duration” assets. In contrast, growth stocks tend to pay less in the way of current dividends. Investors in these stocks are counting on cash flows farther out. Using the discounted net present value theory, longer duration growth stocks deserved to be punished more by the threat of rising rates.
Looking ahead, investors need to consider the strength of the broader economy and how central banks are likely to respond to the ongoing inflation threat. If inflation stays hot and the proverbial monetary “punch bowl” is withdrawn faster than expected, we will likely see further volatility.
However, if indeed the recent upward shift in the US Treasury yield curve is pricing in seven to eight 0.25 per cent rate hikes over the next two years, bond yield and stock price normalisation has already begun in earnest. Assuming most bellwether corporates are able to achieve nominal earnings growth again in 2022, equity markets may resume their upward trend.
Under the discounted present cashflow premise, major equity markets are largely behaving rationally. Among sectors, financial companies and banks in particular have been gaining momentum even as long duration technology stocks suffer.
After many years of regulatory restraint, banks are finally allowed to return cash to shareholders through stock dividends and share buybacks. Furthermore, most bank net interest margins benefit from higher rates where more of their assets such as loans and securities can reprice higher than their liabilities such as deposits and borrowings.
The normalisation of economic conditions will hopefully also include an eventual end to the pandemic itself. Certainly, each advance in the development of vaccines, therapeutics and personal protection technology brings increasing hope for a normalisation of everyday life. Industries such as leisure and travel have lagged the broader economic recovery but are ripe for a rebound if we can reach the final stages of the healthcare crisis.
Bryan Dooley, CFA is Chief Investment Officer at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.