by Dr. JoAnne Feeney
Federal Reserve Chairman Jay Powell announced a shift to an “inflation averaging” rule last week at the virtual Jackson Hole monetary policy conference and many investors are wondering whether this should alter portfolio strategy. The short answer is, for now, no. But what of concerns that the Federal Reserve is continuing to feed the market’s rise even as the real economy shows a nearly 10% year-over-year decline in output? Is the market too expensive at nearly 23 times forward earnings for the S&P 500 companies? Surely, the Fed’s move must have some importance for the economy and markets.
It does, on both counts. First, the Fed’s new rule tells us to expect low interest rates for longer, which the market has already figured out. This means inflation can run above 2% without triggering a Fed rate increase, also as widely expected. The Fed also made clear it will be more focused on using low rates and “other tools” to focus on maximizing employment with little concern for inflation, which is still below its target. So through cheap money policy, balance sheet expansion, and select asset purchases, the Fed helps firms to borrow to survive this period of Covid-induced demand weakness and to ready the ramp in production needed to support the return of higher consumer demand. This should ease the way for firms to bring back workers. And while companies and investors already expected low rates to persist for multiple years, the Fed’s announcement provides a greater degree of certainty, which allows for better planning and encourages investment in plant and equipment and hiring. The tailwinds behind economic recovery just got a little stronger, but it isn’t a game changer.
Second, the new rule states that the Fed plans to allow inflation to run “moderately” above 2% for “some time” after periods of sub-2% inflation. Since the U.S. economy averaged well below 2% (Core PCE) inflation for the last ten years, investors rightly expect the Fed to avoid rate increases for the foreseeable future. But not forever. Eventually, inflation will climb and market interest rates will have to move higher to compensate lenders for the erosion in purchasing power created by that inflation. Since the Fed is more inclined to tolerate higher inflation, longer term interest rates should rise and steepen the yield curve. This steepening began on Thursday with the Fed announcement. But note that U.S. interest rates remain at historically low levels so the slight rise in long-term rates is likely to do little to discourage longer-term borrowing (such as mortgages).
Federal Funds Rate – 62 Year Historical Chart
For equity markets, the greater certainty of low interest rates directly raises company valuations. Not only should investors discount the future stream of profits and cash flows using lower yields, but the reduced uncertainty also decreases the risk premium attached to those profits and cash flows. Note that this has a greater impact on companies with faster earnings growth, since much of their value derives from future earnings, rather than current earnings. Moreover, the slightly stronger economic tailwinds described above should help company profits return to growth more quickly. The market’s strength in anticipation of, and on the heels of, that Fed announcement is warranted.
But remember that not all stocks are rising. Companies that benefit from the structural change in behavior brought on by the pandemic are seeing their stocks surge higher, while companies providing services that place consumers at risk are still down sharply. In the middle are those companies that rely on the broader economic recovery—banks, for example. And because the S&P 500 Index uses market-capitalization weights, it is dominated by the companies benefitting from the ongoing transformation of behavior. So, while the S&P 500’s multiple of 22.8 times expected forward earnings appears high by historical standards, the heavy weight of the MFAANG companies (Microsoft, Facebook, Apple, Amazon, Netflix, and Alphabet, Google’s parent) in the Index, and the fact these companies benefit from the structural shift induced by the pandemic, provides solid justification for it.
We expected rates to remain lower for longer. The Fed confirmed that and also pointed to higher inflation (and rates) eventually (which is no surprise, either). This brings us back around to the question of portfolio strategy. Because of the structural shift in behavior, there will likely continue to be a sharper distinction between winners and losers over the next several years (as there has been for the last six months), making stock picking even more important than during a typical economic recovery. In addition, the Fed’s action suggests a bit more strength behind higher growth companies, while pointing to lower total return than historically for fixed income securities. This may suggest a shift in the optimal mix of equity and fixed income, since we’re in a low interest rate world for a while. On the one hand, equity’s expected return has risen, while fixed income’s has fallen. On the other hand, equities remain a bit riskier than they were last year or five years ago, since we are still deep into a pandemic and the future path of economic activity could be volatile. When interest rates start to rise—and bond prices to fall—that tradeoff will tilt even more decidedly in favor of equities. As always, the fixed income component of a portfolio provides stability in value. But the cost of that stability is higher now, coming in the form of low returns. And the cost will increase further when we ultimately approach a higher inflation and interest rate period. The Fed’s action puts off that shift to the more distant future—for now.
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